Can Severance Take the Place of Your Emergency Fund After a Layoff?

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In April, the U.S. economy added 175,000 new jobs and the unemployment rate held fairly steady at 3.9%. But even in a fairly strong labor market, there's always the chance that your job might land on the chopping block -- not because of something you did, but due to circumstances outside of your control.

That's why it's so important to have money in a savings account in the event of a lost job. That's money you can use to cover your bills until you're employed again, thereby sparing yourself the cost of carrying a credit card balance.

But what if you're confident you'll be eligible for severance in the event of a layoff? Can that payout take the place of your emergency fund , or do you still need savings of your own?

Can you really count on getting severance?

The extent to which you can plan to fall back on severance in the event of a layoff really hinges on the employment contract you signed. If there's language in that contract spelling out a severance package, and you know you qualify for compensation in the event of being downsized from a job, then you may be able to take some comfort in the money that's coming your way. And in that case, you may be able to get away with having a smaller emergency fund.

Let's say your employment contract expressly states that any worker who's laid off gets severance equal to one month of pay per 12 months of employment, up to a total of 12 months of compensation. If you've been at your company for 15 years, your contract basically tells you that you'll be getting your salary for a year if you're let go. In that case, you may not need a huge emergency fund -- though you should always have some emergency cash on hand for expenses not related to job loss, like home or car repairs.

However, if there's no specific language about severance in your employment contract, then severance is something you can't rely on. It's that simple.

What's more, even if your contract spells out the terms of how severance is paid, to get that money, you may be required to sign a separation agreement with unfavorable terms. A separation agreement might contain language that limits your ability to seek work elsewhere, which would make signing it a poor choice. But your employer might also withhold your severance pay if you don't sign its agreement.

Now, in this type of situation, it's a good idea to get an employment lawyer involved. They may be able to help negotiate the terms of your separation agreement so you can get your severance and be on your merry way. The point, however, is that even when severance is "guaranteed," you might still need a backup plan in emergency fund form.

Don't neglect your savings

It's nice to be able to have severance pay to fall back on in the event of a layoff. But don't use that as a reason to avoid building an emergency fund.

Not only might you need cash for unplanned bills that arise while you're still gainfully employed, but it might also take more time than expected to find a new job after losing one. So the more money you have in the bank, the less stress you'll have in that regard.

Your job, for example, might give you a year's worth of pay following a layoff. In many cases, that's enough time to find work. But if you have a very specialized or upper-level role, it might take more than 12 months to get hired elsewhere. And you don't want to land in a situation where your severance has run out and you're forced to take any old job because you don't have the savings to stay the course and find a job you want.

So at the very least, aim to build an emergency fund with enough money to cover three months of expenses. Having that sum of cash on hand buys you options either way.

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