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Emergency cash a necessity, not luxury

When it comes to planning for those unexpected but inevitable financial speed bumps in life, Americans seem to think denial is a reasonable strategy. While there’s no way to predict when an emergency will strike or to know how expensive it will be, you can plan. An emergency cash fund is your best line of defense.

It’s wise to eventually build up a six- to eight-month fund, because there’s a good chance you won’t earn a paycheck for at least that long if you’re laid off or become too sick to work. Even if you have disability insurance, it often doesn’t kick in for the first six months of your disability.

Compounding the problem

Let’s face it, even relatively "small" emergencies can send your finances into a tizzy. An unplanned medical test or two can quickly add up to a four-figure doctor’s bill even if you have health insurance.

Or say your house needs some serious unplanned repairs. Tapping into your homeowner’s insurance can backfire. First, you’re going to have the deductible to deal with, so you’ll need some cash regardless. And when you actually use the insurance, you’re probably looking at a hike at your next policy renewal.

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Consumers are also quick to pull out their credit cards to pay for unforeseen expenses. That’s fine if you qualify for a no- or low-interest-rate card, but with the average rate around 12 percent, plastic isn’t a smart solution for everyone.

The same goes for borrowing from your 401(k) plan. I’ve covered this territory before, so here’s a short-recap: The money in your 401(k) is pre-tax, meaning Uncle Sam has yet to take his cut. When you take that money out as a loan, you’ll eventually have to pay it back, and that’s going to come from money you’ve already paid taxes on.

Then, when you retire and start making 401(k) withdrawals, the same money you used to repay your loan is going to be taxed again. All withdrawals are subject to income tax. Paying taxes twice on your money isn’t a reasonable strategy.

Besides, if your emergency is that you were laid off, you won’t be able to take out the loan anyway. And withdrawing money outright from a 401(k) means you lose twice: If you’re under 591⁄2, you’ll have to pay an extra 10 percent IRS penalty for an early withdrawal, and you’ve just gutted your retirement savings.

Plan, don't procrastinate

OK, now let’s get smart and actually plan for the "what ifs" in life.

As a stopgap, if you have a FICO credit score of 720 or higher, you could shop around for a credit card that will charge you no interest or a very low rate. But don’t use the card — it’s only for a true emergency.

A Roth IRA can also bail you out. Because the money you invest in a Roth has already been taxed, you’re free to withdraw your contributions — but not your earnings — with absolutely no tax or penalty, regardless of your age. Of course, this is a last-resort move. As I said, raiding your retirement savings to cover a shortfall today is not an ideal solution.

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Thinking ahead

Here are some other savings possibilities:

• Boost your car and homeowner’s insurance deductibles to at least $1,000. The chances that you'll ever need to make a claim on them are fairly low, and by opting for the higher deductible, you can reduce your overall premium costs by 10 percent or more.

• Use the same company for your car and homeowner’s insurance. That can get you a further premium reduction of around 10 percent.

• Ditch your land line if you can get by with just your cell phone. Depending on your plan, you might be able to free up $30 to $50 a month.

• Adjust your federal tax withholding. Why wait more than a year to get back taxes you paid but didn't owe? Adjusting your withholding means less cash deducted from your paychecks. That’s money you can put to work today in a cash stash.

Suze Orman is a best-selling author and Emmy award-winning TV host whose new book, "Women and Money," was published in March 2007. For details, please visit www.suzeorman.com.

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