Financial Safety Nets: When to Build and Destroy Different Financial Safety Nets

Financial safety nets: Important when you need them, but a financial waste when you do not.

Saving money gives us extra financial security so we can remove stress about expensive emergencies.  Most of us know we want to save enough money for an emergency fund to cover an unexpected job loss or a medical crisis, but fewer people think about what kinds of financial safety nets we need for different phases of life.

While an emergency fund helps protect us from basic financial emergencies, life gets more complicated as we get older.  Providing for dependents, experiencing declining health, and even our increasing wealth require different financial safety nets than we initially needed in our 20s.  As time goes on and we grow our wealth, retaining financial safety nets that we once needed can also become a waste of money.  Navigating when to add and drop financial safety nets can be complicated, but our timeline takes you through some typical life milestones that force many of us to modify financial safety nets.

Phase One: Build Your Emergency Fund and Basic Health Security

When you are just starting your wealth building journey, saving money for a basic emergency fund is key.  Start by saving for three months of expenses as quickly as possible, and continue to save for six months to a year of expenses to create the kind of safety net that eliminates fear of sudden job loss.  When you have six months to a year of expenses saved, you can feel confident that you will figure out a new income stream before you run out of money.

This emergency fund should be a high-yield savings account (HYSA) for two reasons.  First, HYSAs are accessible at any time.  If you encounter an emergency, you can immediately transfer money from your HYSA to a checking account.  Second, you will receive interest on money saved in a HYSA.  This allows your money to keep growing to better account for inflation.  If you instead kept cash under your mattress, the $1,000 you saved today might be worth about $800 in today’s dollars when you use it in a couple years.  Keeping your emergency fund in a HYSA means you can forget about it once you have sufficient funds to provide you financial security.

At the same time that you are saving to build up your emergency fund, you should also take advantage of any job benefits you have that can add some financial security to your life.  Specifically, if your employer offers health insurance, enrolling in a high-deductible health plan (HDHP) and contributing to a health savings account (HSA) can help you build a health emergency fund.  This is especially important for most younger savers because HDHPs make the most sense while you are young, healthy, and do not have dependents that may incur more medical expenses.

Health savings accounts are tax-advantaged accounts, meaning you do not have to pay taxes on the money you contribute directly to an HSA.  Some employers even provide a partial match for HSA contributions, similar to a 401(k) match, but this is less common.  No matter what, starting an HSA while young provides an enduring health safety net because the money you contribute is invested and will continue to grow until you eventually need it.  If you manage to survive all your working years without a medical emergency, your HSA effectively turns into a retirement account, so you simultaneously protect yourself from costly health emergencies while investing for retirement.

The final financial safety net for a young employee is to explore whether your employer offers automatic or low-cost life insurance.  My previous employer offered life insurance equivalent to one year of salary at no extra cost to me, and this is a common practice.  If your employer’s life insurance is free or of negligible cost, it is worth signing up even while young.  This small amount of life insurance would be enough to help whoever would be responsible for your affairs to have enough money to cover the extensive costs of dealing with an estate without stress.  In addition to signing up, make sure you elect a primary and secondary benefactor, again to alleviate stress for your surviving loved ones.

While you are young, you do not need any additional life insurance since nobody else is depending on your income!  As long as your life insurance through your employer is enough to cover expenses related to dealing with your estate, you are set.  Do not get swayed to buy a $500,000 life insurance package at age 22 when you have no dependents!  You do not need it.  Additionally, once you have enough wealth to cover your own expenses in the event of your sudden demise, you can stop paying for your employer’s insurance if it has a small cost.  You only need enough to not cause surviving loved ones financial stress.

Phase Two: Overlap Safety Nets

Once your emergency fund is large enough to cover your financial emergencies, you will probably start saving in additional HYSAs targeted at achieving other financial goals.  These may include big goals like purchasing a home, mini-emergency funds that are focused like a car repair fund, recurring expenses for hobbies like a golf fund, or money to fund future events like a concert or travel fund.  You also may have HYSAs for groceries, gifts or donations, and more.

When you start saving $50 here and there towards these funds, you still need an emergency fund.  It can feel like you spend money from your concert fund as quickly as you add it to a HYSA, and that is okay as long as it is money you earmarked for your concert fund!  However, if you are saving money in a lot of different categories, they are likely to grow with money that is not immediately used over time.

At the point that your thematic HYSAs become larger than your emergency fund, you no longer need an emergency fund.  I do not have an emergency fund!  But I have ten HYSA buckets for travel, my Etsy business, fun and miscellaneous, rugby and health, donation matching, gifts, baseball, food, car expenses, and extravagance.  If I encounter an emergency, odds are I will not need to book a luxury vacation, buy World Series tickets, pay for traveling to rugby nationals, pay for major car repairs, and make a donation to a favorite charity in the same week.  In fact, I know that will not happen because rugby nationals are in May, the World Series is in October and November, and I never take luxury vacations when either of those things are happening.  In other words, even if I just drained one of my HYSAs, I still have others in the event of an emergency.

One note on this: If you are saving for a down payment to purchase your first home, you may want to exclude that from the total of your thematic HYSA buckets since you intend to spend the entire amount in the near future.  This could also be true of any categories for specific expensive purchases or events where you plan to spend a lump sum, like purchasing a truck or paying for a wedding.  Exclude those from your HYSA thematic bucket total when deciding whether to get rid of your emergency fund, and just include more consistent categories.

Waiting to reallocate your emergency fund until you have as much money in your other HYSAs is conservative, and the more risk tolerant can probably do it once your other HYSAs are at least 50% the size of your emergency fund.  However, if you are more risk averse, wait until you have doubled your emergency fund.  Either way, once you are ready to reallocate, take the money in your emergency fund HYSA and distribute it across each of your thematic HYSAs to double the value of each of them.  By doing that, they all should have more than you would expect to spend in any normal year.

I call this the bucket overlap method of maintaining an emergency fund because more than enough money for an emergency fund is baked into my HYSA buckets.  While it feels like you are just destroying a financial safety net, you are actually adding financial freedom to your life because you are telling yourself you can spend more on any of the areas of your life that give you joy as long as you do not spend on all of them at once.  You suddenly have twice as much money for travel if an unexpected opportunity arises, or you can afford playoff tickets that you could not before.  You can empty any bucket if the event is significant enough—you just cannot empty every bucket.  Your HYSAs have grown enough to cover emergencies and make sure you can prioritize the spending that makes you happiest.

Phase Three: Safety Nets for Dependents

You do not need life insurance beyond one year of salary to deal with funeral and other expenses if you do not have dependents, but the second you have dependents you may need more safety nets to make sure their lifestyles are supported.  The exact amount you need is a bit more nuanced:

1. If you have enough money in retirement and brokerage accounts to support your dependents in perpetuity for a dependent spouse, and/or through childhood for children, then you do not need life insurance.

2. If you have children but your spouse or partner also has an income, you probably want a small sum of life insurance to guarantee that your spouse and children can continue living in the same home and maintain the same lifestyle.

3. If you have a dependent spouse and children and do not have enough in retirement or brokerage accounts to support all of them, you need life insurance to cover the difference.

In other words, you absolutely do not need life insurance of an amount that would support dependents in perpetuity by itself if you have any other wealth.  Any other wealth you have reduces the amount of life insurance required to continue supporting your dependents.  Most parents need life insurance initially upon having children, but some are sold on larger policies than they need because they do not consider their preexisting wealth in IRAs, 401(k)s, HYSAs, or elsewhere.

Additionally, you should need less life insurance over time until you can eventually go without it.  If your life insurance is used correctly as a safety net for your dependents, you likely only need term life insurance.  Life insurance is a bandaid in the event that something happens to you so that your dependents can continue to live comfortably and do not experience a catastrophic financial event in addition to an emotional one.  Once your other investments grow large enough to support your dependents in perpetuity, or your children through their childhood (or college, age 25, or whatever other threshold you choose), you do not need life insurance.

Most people should eventually cancel all life insurance plans once they have accumulated enough wealth.  The exceptions may be individuals who have dependents with less predictable preexisting health conditions.  If your spouse or child has health issues that require significant medical expenses, around-the-clock care, or increasing assistance over time, it may be worth keeping your life insurance to make sure the spouse or child can afford the care they need in the event that you are no longer there to provide it.

Even if you do not have any dependents with preexisting health issues, opting for better health insurance when you have children is another important financial safety net.  Having a child is expensive all by itself, and children continue to have more medical costs in their early years of life due to more regular doctor’s visits, many vaccinations, inevitable illnesses picked up at school, and the injury they sustain from a tumble on the playground.  Spend on better insurance while kids are young.  This likely means you will opt for a premium plan rather than a HDHP, meaning you can no longer contribute to your HSA.  That is okay, though, because your HSA is still there to cover you in an emergency, and you will be happy that your younger self contributed to it!  You can still use an HSA even if you can no longer contribute to it; those funds are yours!

Phase Four: What Safety Nets to Remove with Wealth versus Retain for Health

Once you acquire enough wealth to support yourself in perpetuity, you no longer need an emergency fund because your combined wealth is one giant emergency fund protecting you from whatever financial unpredictabilities arise.  Emergency funds are for individuals who would worry about a $20,000 surprise roof repair or car replacement.  Once you become financially independent, that expense should not phase you.  If you did not already get rid of your emergency fund, definitely start the bucket overlap method once you are financially independent.

You also do not need life insurance once you are financially independent.  Your wealth is your life insurance.  Make sure whoever will manage your affairs after you pass is left a significant portion of your wealth to deal with your affairs without stress.  If you have dependents, the majority or entirety of your wealth should be left to them.  As long as your surviving loved ones are supported, you have enough wealth and no longer need life insurance as a temporary safety net.

No matter how much wealth you have, you need health insurance.  If you have children when you are young, you may reach a phase where you go back to a HDHP and contribute more to an HSA before entering your older years of life.  That is great because your HSA provides a health safety net and later becomes a retirement fund.  However, once you start aging, pay for good health insurance.  It will be expensive, and it will be worth it.  There is no point in having wealth if you do not also have your health to enjoy it, so health insurance provides the one enduring financial safety net that we retain for life.