Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Why you should have cash for life emergencies
Investing is undoubtedly the best way of building up a nest egg, but it’s important not to lock away all your wealth.
Although cash has become somewhat of a dirty word in the current era of rising inflation and poor returns, it could be a lifesaver if an emergency strikes.
Equities vs cash – what are the returns?
Putting your money away to prepare for your future – whether that’s retirement, buying a home or university education – is an incredibly wise move. We’d argue it is a particularly good if you’re investing this money in the stock market.
Long gone are the days when Cash ISAs offered returns of 5% or more. Today, it’s a struggle to find Cash ISAs with returns of just 1%, which is paltry when you compare it with the current UK inflation rate of 2.3%.
Equities – another name for stocks and shares – have achieved 5.6% average annual return over the past 50 years, claims the 2016 Barclays Capital Equity Gilt Study.
If you want your money to grow, equities are likely to offer the best combination of risk and return for the majority of individuals.
Why shouldn’t I put everything in equities?
Experts strongly advise not to invest all your wealth into the stock market. Equities should be viewed as a long-term investment, which means investing in them for at least five, or even 10, years.
The reason for this is that while equities rise over the long-term, they will probably go through some ups and downs along the way. If you suddenly need to access your wealth and your shares or funds have gone down in value, you’ll end up crystallising your losses.
There are lots of reasons why you might need access to your money – a period of unemployment, ill-health, a major expense that isn’t covered by insurance, divorce, and so on.
Because these events could strike anyone at any time, it’s advisable to keep some money aside in cash that can be accessed quickly.
How much should I keep in cash?
The exact amount of money you put aside as an emergency fund will depend on what other assets you have and how quickly they can be turned into cash.
The split between your savings and investments will also be determined by your risk appetite.
Some experts suggest setting aside the value of three months’ essential outgoings in cash. For example, if you usually spend £1,000 a month on bills, food and other things you can’t live without, you could aim to have three times this amount in emergency savings.
Tom Riley, head of savings at building society Nationwide, recommends saving an emergency fund that is the equivalent of three months’ salary.
‘This can help take the pressure off if you lose your job or are unable to work for a period of time, but also useful if you receive an unexpected bill,’ he says.
Trevor Clark, operations director at financial advice firm Rutherford Wilkinson, suggests analysing your costs such as money needed to repay a mortgage, loans or credit cards.
‘Debt that accrues interest at a higher rate than you would earn on saving cash should be paid off first and foremost,’ he says.
If you’re unable to create an emergency fund straightaway, you could start by putting a regular amount aside each month, perhaps via a standing order.
Where should I put my emergency fund?
As your fund is earmarked for emergencies, being able to access the money easily is key. You don’t want to be putting this portion of your wealth into saving and investment products with fixed terms; otherwise you could face paying an exit penalty.
Easy access Cash ISAs are useful because they shelter your money from tax, but slightly better returns are to be found in savings accounts.
The flexible RCI Bank Freedom Savings Account pays 1.1% interest. You can open it with a minimum of £100 and make unlimited payments and withdrawals.
TSB’s Classic Plus Account pays 3% on balances up to £1,500, although we’d assume most people would need a higher amount in emergency savings. Therefore you may wish to put the maximum permitted in the TSB account to get 3% interest and the rest somewhere else.
You could also consider a regular saver account. These accounts are designed for savers who want to put a regular amount aside each month and typically offer a higher rate of interest – First Direct, M&S Bank and HSBC all offer 5%.
You’ll need to have a standard current account with the provider to qualify and there are restrictions on how much you can pay in. The rate will drop after one year when you should consider switching to a better deal. (EP)
What about tax?
Holding cash in a traditional savings account means you don’t enjoy the tax benefits associated with an ISA. However, the personal savings allowance means a basic rate taxpayer can earn up to £1,000 and a higher rate taxpayer up to £500 in savings income tax-free each year.
‘For the latter, an individual would need £10,000 in savings earning 5% to reach £500 in interest. Therefore, while large amounts of money invested in the market and protected in a tax shelter make sense, smaller sums held as cash will have to work hard before exceeding the personal savings allowance,’ explains Clark at Rutherford Wilkinson.