Q: I often hear that you should keep three to six months’ worth of living expenses in an emergency fund, and that some people should keep even more. But in a low-yielding environment, that’s an awful lot of money to have sitting in the bank earning next to nothing. Any advice?

A: You’re right–the past few years have brought a negative convergence for emergency-fund investors. A still-shaky economy and uncertain job market have underscored the importance of building a cash cushion to cover your costs in case of job loss or big, scary, unanticipated expenses such as medical bills or home repairs. At the same time, available yields on emergency-fund-appropriate investments have shriveled to next to nothing.

What to do? Here are some tips:

1. Customize, based on your own situation.

Three to six months’ worth of living expenses is a reasonable starting point when setting your emergency fund amount. But think of it as just that: a starting point. From there, you’ll want to customize your emergency-fund amount based on your own situation. The basic question is this: How much time would you want to replace your job if you lost yours? The key swing factors that should affect your decision are how flexible you are in terms of your career choices and lifestyle.

Consider holding a larger emergency fund (six months’ to a year’s worth of living expenses–or more) if you:

•  Have a high-paying job
• Hold a position in a highly specialized field
• Are self-employed
• Work on a freelance/contract basis
• Have dependents
• Have a nonworking spouse
• Have high fixed expenses, such as a mortgage, auto loans, and tuition bills
• Have a pre-existing medical condition that could result in hefty health-care bills if you were forced to purchase private health insurance

On the flip side, you may be able to get by with a smaller emergency fund if you:

• Have a good degree of career flexibility because you are in a lower-paying position and/or haven’t yet developed a specialized career path
• Have other sources of income that could help defray a large share of household expenses, such as a working spouse
• Have a great degree of lifestyle flexibility (for example, you would be willing to relocate or get a roommate)

2. Focus on the essentials

Setting aside even three months’ worth of living expenses might sound like a daunting sum, particularly if you look back on your real-life spending habits. But once you strip out discretionary expenses that you could easily live without if you needed to, your emergency-fund amount is going to look a lot more manageable. To help find the right emergency-fund target, look back on your fixed expenses during the past several months: mortgage or rent, taxes, utilities, insurance, car payments, and food bills.

Bear in mind, however, that one key expense category could spike up if you lost your job: health-care costs. Your company’s human resources administrator should be able to provide you with a quote on what obtaining COBRA continuation health coverage would cost, and you can also go to ehealthinsurance.com to obtain a range of insurance quotes for a person/family in your age range.

3. Build a two-part emergency fund.

If you’ve decided to be conservative and build a large emergency fund–and I think that’s a good strategy for those of you with higher-paying jobs and high fixed costs–you might consider splitting it into two pieces. For example, you might park three months’ worth of living expenses in a traditional emergency-fund parking place (or a combination of them): your checking and savings account, a CD, money market account, or money market mutual fund.

To help address the fact that those truly safe investments are yielding next to nothing, you could then put another nine months’ worth of expenses (or more) in a vehicle that would deliver a slightly higher yield in exchange for modest fluctuations in principal value. A short-term bond fund such as  T. Rowe Price Short-Term Bond or Vanguard Short-Term Bond Index could be appropriate for this role. If you’re in a higher tax bracket, consider a short-term municipal fund; Fidelity and Vanguard field.

4. Multitask through a Roth.
What if you’re trying to build an emergency fund while saving for retirement at the same time? If that’s you, you can consider building at least part of your emergency in a Roth IRA. This can be a viable option because the Roth, unlike a traditional IRA or 401(k), enables you to withdraw  your contributions at any time and for any reason prior to age 59 1/2. Under a best-case scenario, the assets in your Roth would increase until you began withdrawing them in retirement. But if you lost your job, you could withdraw your Roth contributions if you needed the money to cover living expenses.

The key drawback to this approach is that ideally, you’d hold any assets you have earmarked for your emergency fund in something safe, such as a money market fund or CD. But those safe investments have very low long-term return potential, making them inappropriate if your goal is long-term growth for retirement.

5. Set up additional safety nets.
Finally, while emergency funding is on your mind, investigate additional safety nets that you could turn to if you’ve exhausted your emergency assets. For example, check to see whether your company’s retirement plan allows for loans. Because you’ll pay interest to yourself rather than a bank when you take a 401(k) loan, tapping these assets is preferable to turning to a bank loan or credit card if you find yourself in a financial bind. (The key downside, of course, is that you’re short-shrifting your own retirement savings.)

Obtaining a home equity line of credit may also make sense for homeowners who have built up substantial equity in their properties. The key to making this strategy work is to use the HELOC only in case of a true financial emergency and after you’ve exhausted other types of funding, rather than to cover discretionary expenditures such as cars and vacations.

Post courtesy of Christine Benz at morningstar.com.