Understanding income volatility and emergency savings

What is income volatility in simple terms?

Income volatility refers to unpredictable fluctuations in earnings that can make budgeting and planning ahead more complicated.

While income volatility can be caused by a hardship, like losing a job, it can also be a regular part of life for many people whose earnings fluctuate because of the nature of their work. For example, entrepreneurs, real estate agents, and gig economy workers, like rideshare drivers and freelancers, often experience income volatility.

A salesperson working on a commission-based pay structure might see less income during a slow month compared to a busy one. Other reasons for income volatility include leaves of absence for maternity, caretaking, or travel. There's no one-size-fits-all approach to handling income volatility, but smart planning can significantly increase your chances of financial success.

The impact of income volatility on financial stability

Income volatility can reduce financial flexibility, making it difficult to pay for big-ticket items like a child's education or plan for special events like vacations. But it isn't just a financial strain—it's also a mental one. And financial concerns can amplify stress during an already anxiety-inducing event, such as a medical leave or job loss.

Income volatility can also make managing everyday cash flow more challenging. For example, a salesperson at a department store working at an hourly rate might see less income during a slow shopping month compared to a busy one. During the slow month, their paycheck may not be enough to cover basic expenses, and they might use their credit card to cover their bills. In the following month when they receive a larger paycheck, they may use some of it to pay down their debt or make larger purchases. This can create a downward spiral where spending becomes larger than earnings, leaving them in a precarious financial position.

In this cycle of spending and income mismatch, many may choose to cash out their 401(k) when they leave their job. In fact, among participants in Vanguard-administered 401(k) plans, we find that hourly workers—a group that tends to see more unstable income than salaried workers—are twice as likely to cash out their 401(k)s when leaving an employer. But cashing out a 401(k) not only incurs penalties and taxes but also reduces your retirement savings, potentially leaving you with less financial security in the future.

Under already stressful financial circumstances, planning can feel even more complex and overwhelming. But while some jobs with volatile income offer more flexibility, proactive budgeting, saving, and investing can help you keep your freedom.

Importance of emergency savings

You can think of your emergency savings as cash you use to cover debts and gaps in income, but it can also serve as the cash you use to seize opportunities. That may mean going on an international trip, taking a class, or pursuing a creative endeavor. Having an emergency fund also improves financial behavior and overall wellness.

In fact, having just $2,000 of savings set aside can increase financial well-being by 21% and decrease time spent thinking about finances by about 4 hours per week—that means more energy to focus on increasing your income or simply enjoying your life.²

If the primary goal for a sum of money is long-term growth, for most investors it should be in stocks and bonds. However, since you need an emergency fund, it makes sense to also give that money the chance to grow by putting it in a savings vehicle that earns more than a zero-interest checking account or low-interest traditional savings account. Many high-yield savings options allow you to tap into your cash when you need it and give it the opportunity to grow in the meantime.

Though you may need a higher cash buffer than those with a more stable income, you can still benefit from competitive yields by choosing the right savings option.

Steps to save for both the short and long term

Fluctuating income doesn't have to mean unstable finances—but it takes some planning. Here are some key steps:

1. Assess your financial situation: Take time to understand the patterns of your income fluctuations. Factors may include your industry, your tenure, and your personal needs for flexibility and freedom.
2. Eliminate high-cost debt: Prioritize paying off high-interest debts, such as credit card balances, to reduce financial stress.
3. Create a budget: Track your income and expenses to identify areas where you can cut back and save more.
4. Build your emergency fund: Add to your emergency fund expenses in a high-yield cash investment option like a MMF, CD, HYSA, or cash management account such as the Vanguard Cash Plus Account.
5. Invest: Building your savings doesn't mean ignoring investments—they should work together. Your retirement depends on your contributions today. And eventually, your investments could even serve as an additional income stream. Build your investments around your financial goals for long-term success.
6. Enjoy your flexibility: Creating a financial plan gives you freedom. Use your savings to spend time with your children, care for a parent, or explore your passions. Better planning means more choices.