How to develop your financial safety net

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How to develop your financial safety net

It’s easy to feel overwhelmed when you talk about money. Most of us know how easy it is to get caught up in the endless cycle of paying off debt and the toll that takes on you emotionally. It’s challenging to save money and get ahead financially when you’re just trying to make ends meet, even if you do have a financial plan in place.

The reality is that financial emergencies are bound to happen no matter how much careful planning you do. That’s why it’s important to develop a financial safety net so you can rest easy knowing that you can roll with the punches.

When you are building your financial safety net, you need to think about how you will protect yourself and your family from risk, while also finding ways to save and invest for your future. Shoring up these financial areas will provide a safety net for all of life’s "what if" questions.

Build your emergency fund

The first step in your financial safety net should be creating a special savings account just for emergencies. You spend all your time paying other people, and now is the time to pay yourself first. The problem is that many people overlook the importance of creating an emergency fund and instead rely on their savings accounts like a 401(k) as a safety net.

Your emergency fund should have three to six month’s worth of expenses (or eight months, if you’re Suze Orman) saved to cover all sorts of money emergency situations like an unplanned trip to the hospital, a roof that needs replacing, or an accident where you need to pay your car insurance deductible.

Emergency funds should be saved in a separate savings account from your overall savings so you can be sure not to touch it. This will put you ahead of a lot of people – 46% of Americans can’t cover a $400 emergency expense. We name just a few examples above, but there are so many different situations that arise as you go through life that require a liquid cash cushion to pay for these unexpected expenses.

Take some time to figure out what your fixed expenses are (they’re the expenses that you have to pay every month, like your mortgage), and work backward to create your emergency fund. Saving three to six month’s worth of expenses could take a while, so break the total you need to save up into bite-sized bits and put your savings on auto draft each month to treat it like a bill that you have to pay to make it a little easier.

Protecting your family

Protecting your family with term life insurance is a crucial piece of your financial safety net. A life insurance death benefit can be a lifesaver for your family should something happen to you and provide immediate liquidity for your beneficiaries. The life insurance death benefit can be used to pay off debt, put towards your children’s college education or simply be used to provide cash flow each month.

Term life insurance is worth it even when you're young and healthy because it’s inexpensive, and you can choose anywhere between a 10- and 30-year term. Your premiums will stay the same during the length of your term, which means you can add the cost of life insurance to your monthly budget and not have to worry about premiums increasing before the term expires.

It’s never been easier to purchase term life insurance online. It takes less than 5 minutes to find the term length and coverage amount you need for you and your family.

Protecting your income

You've probably never thought about it, but your most valuable asset is your ability to earn an income. Without your salary, financial disaster is likely to occur – and fast. How would you pay for all of your bills each month if you didn't have regular income coming in? We've already discussed the need for an emergency fund, and if you don't have one in place, losing your income could end up being a big financial blow.

Long-term disability insurance is one area of risk protection that most people don’t understand but should certainly pay attention to. Many people confuse long-term disability insurance with the common form of short-term disability. While having some short-term disability insurance is important, adding long-term disability insurance will ensure that you have some percentage of income (long-term disability usually pays up to 60% of your gross pay) for injuries lasting over 90 days. In fact, the odds of you having an injury that lasts longer than 90 days if you’re under the age of 40 are much higher than the odds of you passing away.

Do you need long-term disability insurance? It's entirely possible that your company might offer long-term disability insurance as a benefit that you can take advantage of, so make sure you check with your Human Resources department. Either way, you can easily get a long-term disability quote for an individual policy that will provide you benefits no matter where you work.

Prepare for retirement

Creating a robust savings plan for retirement is one of the best financial decisions you can make because it gives you choices later in life. Regardless of any market ups and downs, saving for retirement early allows you to make decisions about how you want to live your life in the future and provide a stellar financial safety net down the road. More importantly, saving for retirement now will help protect you against the future emergency of running out of money in retirement.

The unfortunate reality is that most people aren’t saving enough for retirement, which means you either have to work a lot longer (or potentially forever) or dramatically decrease your living expenses. Currently, only 46% of Americans have saved enough in their retirement plans to provide an adequate stream of income in retirement. With life expectancy increasing each year, it’s critical that you save as much as you can while you are working. Many of us will face twenty to thirty years, if not more, in retirement. All of those non-working years will require some sort of cash flow to provide an income stream.

If you have a 401(k) at work, that is the best place for you save for retirement. Most companies offer matching funds, which means your employer will match your contribution up to a certain amount. Most employers set a cap to the amount they will contribute; on average an employer will match 50% of your contributions up to 6% of your salary that you contribute. Matching fund are the reward for being an employee and one of the best ways to build your retirement savings.

Besides a 401(k), you can also invest in an IRA or Roth account. An IRA works just like a 401(k) where you invest pre-tax dollars and your money grows until retirement when you will pay taxes on the amount you withdraw to fund your retirement needs. A Roth works a bit differently. You invest after-tax dollars and your money grows until retirement. When you take money out at retirement with a Roth you will not owe any income tax on those funds. This works well for people who expect to be in a higher tax bracket when they retire, because they’ll have already paid taxes on that money when they contributed, not when they withdraw.

In 2016 you can contribute up to $5,500 if you’re under the age of 50 into either your IRA or Roth and up to $18,000 with a 401(k). Even better, you can contribute to both a 401(k) and either a Roth or IRA to drive even more savings into your retirement savings account and create a stronger safety net for your future.

Purchase an umbrella policy

After you have your emergency fund, main insurance coverage, and retirement savings taken care of, it’s a good idea to see any other holes you might have and patch them if it’s still within your budget. An umbrella policy is a type of supplemental liability policy that you can purchase to cover you over and above the limits that your car insurance or home insurance cover. It’s not a necessity, but it can provide an extra level of protection in incidents that are:

  1. Above your limits – An umbrella policy can pay for expenses that exceed what your current auto or home policies will pay in the event of major claims or lawsuits.

  2. Excluded from your limits – An umbrella policy can pay for expenses related to claims that aren’t covered by your current auto and home policies, like false arrest, libel, and slander.

Say you get into an accident, and you only have $100,000 of body injury coverage on your car insurance policy. However, the person you injured has medical bills exceeding $500,000. Your car insurance certainly won't cover that difference, leaving you high and dry. If you have an umbrella policy, however, you can use that policy to cover the gap and step in where your car insurance policy steps out.

Adding an umbrella policy is a very inexpensive and yet valuable piece to developing a strong financial safety net. A $1,000,000 umbrella policy will run between $100-$200 on average per year for the coverage. You can bundle an umbrella policy with your current car insurance and homeowner's insurance policies and save even more on the cost. Score!

Not sure if you have all of your insurance bases covered before you start on extras like umbrella insurance? Take our Insurance Checkup to see if you have any crucial financial gaps left.

Developing a financial safety net takes some time and effort. Don't get discouraged if you can't check all of these tips off at one time. Instead, create a plan and add any extra expenses to your budget when you can, focusing on creating a stable emergency fund first. It may take some work upfront, but you'll thank yourself for creating a strong financial safety net the next time a financial emergency comes around.