Why You Need an Emergency Fund in the New Year

Aaron Crowe

At least one study has shown that financial worries beat out to-do lists and work stress as reasons for losing sleep, but there's one sure way to avoid sleepless nights: keeping enough money in the bank to cover not only your bills, but also emergencies that might arise.

If the recent recession taught Americans anything, it's that saving for a rainy day is a good idea.

Five years after the financial crisis began, more people are increasing their savings rates and building an emergency fund, according to Fidelity Five Years Later, a study conducted in February 2013. The survey found that 42 percent of respondents increased their contribution rates to savings plans such as retirement accounts, and exactly the same percentage of people surveyed added to their emergency fund.

Fidelity has found that 17 percent of people it surveyed during this economic downturn have lost their jobs or had their pay lowered, says John Sweeney, an executive vice president of retirement and investing strategies for Fidelity in Boston.

[Read: 10 Ways to Upgrade Your Finances in 2014.]

Without an emergency fund, you are more vulnerable to sudden life changes. A job loss or major expense could put you into debt by forcing you to use a credit card more, which could lead to bankruptcy if circumstances fail to improve. With the new year around the corner, now is the perfect time to start planning for your emergency fund. Here are a few things you should know before you begin:

Defining an emergency. Whether you call it a rainy-day fund or an emergency fund, the first goal should be to set aside three to six months of living expenses in case of a job loss, says Paul Golden, spokesman for the National Endowment for Financial Education. During a recession, Golden says, that amount should increase to six to nine months of expenses.

Some financial planners recommend using this kind of fund to account for other unforeseen life events, such as major auto repairs, medical emergencies, legal issues, property damage and significant home repairs. That can equate to $15,000 or so in emergency savings, a sum that can be overwhelming if you're starting from zero. An emergency savings calculator can help clear things up by sorting out how much you have saved and how much you still need to put away, including taxes and investments.

Even a small goal of $500 is worth attempting because it's more attainable and has a positive psychological impact, Golden says.

"If you can show yourself that you can achieve that, then you can achieve something higher," he says.

[Read: What You Should Know About Savings Accounts.]

Setting aside money for basic living expenses, such as rent, insurance, food and utilities, is smart, but remember when facing job loss or another financial crisis, cutting back on dining out, eliminating cable TV and reeling in other unnecessary lifestyle expenses help save money, too.

Six to 12 months of savings for living expenses is best, says Mitchell D. Weiss, an adjunct professor of finance at the University of Hartford in West Hartford, Conn. Three to six months was normal for an emergency fund before the latest recession, but since then more is needed, Weiss says.

Where to put the money. The fund should be sacrosanct, and put in a conservative, liquid account such as a certificate of deposit that can be accessed when an emergency happens, Weiss says. But you don't want to use it for just any expense, such as a vacation, he says.

"Once you use that, you'll rationalize your way to bleeding it dry, and it's not there," Weiss says.

Gaining access to the emergency fund should be inconvenient. For instance, you should consider holding the fund at a bank that's different from the one where you keep other accounts or have paychecks deposited. You also shouldn't be able to go online and transfer money from the fund easily, says David Tysk, a private wealth advisor at Ameriprise Financial.

"They need to treat the money as if it's sacred" and not make it as easy to get as swiping an ATM card, Tysk says.

While Tysk recommends one account, Weiss says multiple emergency accounts can help people plan for different purposes. Instead of one large bucket, for example, you could have several smaller ones for things such as home repairs, medical emergencies and living expenses.

"Separate accounts make sense because it's easier to grapple with the feeding of these accounts," Weiss says.

[See: Your 10-Step Financial Recovery Plan.]

Multiple emergency fund accounts can be a good idea, says Golden, but the main goal is to set up one general account and put money into it regularly. College and retirement accounts should be separate, he says.

Who is more likely to save. Just like the third little pig who built his house of bricks, there are certain people who are more likely to prepare for emergencies than others.

"There are savers and spenders in families, whether it be husband and wife or brother and sister," says Tysk. Savers, as one might expect, are more likely to have an emergency fund, he says.

Some of the savings can come from making lifestyle choices, such as buying a cheaper car or house, and saving annual raises, Sweeney says. People who save for a rainy day shouldn't do so at the detriment of other important goals such as retirement, which should be a top savings goal, he says.

Having money automatically deposited into an emergency fund is a smart way to fund it, says Golden, because you're less likely to notice the withdrawal from a checking account to the fund. "Thinking of savings as a bill is one of the best ways" to build an emergency fund, he says.

As with many financial matters, doing the heavy lifting early by setting a budget and knowing where your money goes can help determine how much can be saved for an emergency fund.

"I think it's harder if you don't go through the prework," Golden says.