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Portfolio 104: Building your emergency fund

In general, you should have plenty of dollars stashed in an emergency fund before you invest a penny. But where will you find the money, and where should you keep it?

By Morningstar.com

You've figured out your goals. You know what they'll cost. So you've put all of your money into your investment portfolio.

Then you lose your job. Where will you get money for food, rent, your phone?

You don't want to dip into that investment portfolio. After all, you've built it with a particular goal and time frame in mind. Touch it now and risk making your future dreams unattainable.

That's why it's important to set aside money in an emergency fund before you begin investing. Here are some pointers for what your emergency fund should cover, how long it should last, and where to put it.

What to include

Don't assume that any future unemployment insurance payments can take the place of an emergency fund. Think of collecting unemployment as a way to strengthen the safety net you're constructing. It shouldn't be your sole support. And if you do collect unemployment, your emergency fund simply will last longer.

We recommend that you cover all conceivable expenses in your emergency fund.

Food and shelter: How much do you spend on groceries each month? If you don't know, now is a good time to start tracking that. And if you eat out a lot, you'll either need to include that, or plan on higher grocery bills. If you have pets, include the cost of their food and care in the tab.

Unless you're ready to move into your brother-in-law's basement, be sure to cover your rent or mortgage payments, too. And don't forget utilities -- gas, electric, water, phone, and even cable and Internet.

Transportation: Unless you plan on never leaving your house, set money aside for your car payments and public transportation. Of course, you'll also need money for filling up your car, for routine maintenance and for more serious problems.

Insurance and health: Be prepared to meet your insurance payments. That means home, auto, life and especially health insurance.

Insurance premiums are often the first things to go when money gets tight. They shouldn't be. One of the quickest roads to penury is to let your health insurance lapse and to find yourself with a serious health condition.

Set aside money for routine dental and eye care, prescriptions and any other health expenses your insurance doesn't cover. Once again, if you have pets, put their vet bills on the tab.

Taxes: Uncle Sam won't care that you're unemployed -- you'll still have to pay income and property taxes. Here's some consolation, though: Your emergency fund also protects you from additional taxes. After all, your tax bill could be much stiffer if you had to sell profitable investments to cover your living expenses.

Finding a new job: It can cost money to make money -- finding a new job won't be free. Consider the cost of producing and sending out resumes. You might want to meet with a career consultant or even take some kind of training. Take those possibilities into account.

How to estimate what you'll need

That's a long list to compile and come up with hard numbers for. The good news is that you don't have to try to brainstorm every conceivable expense.

Instead, track what you spend in the next few months and use that as your baseline. Then add in any other possible expenses, such as taxes or finding a job, that didn't pop up during those months.

If you spent money on movies or your health-club membership, include that. If you're out of work, taking in an occasional flick and working out may help relieve some of your stress.

How long should it last?

Most financial planners recommend setting aside six months' worth of living expenses in an emergency fund.

What if your "emergency" ends up lasting longer than six months? If you take the liberal view of living expenses that we've been taking so far, your emergency kitty likely will last a little longer. Further, we haven't included payments from unemployment insurance. If you do collect unemployment, your emergency fund should last longer, too.

Continued: Treat it as a goal

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