The following excerpt is from Mark J. Kohler and Randall A. Luebke’s book The Business Owner’s Guide to Financial Freedom.
In order to have both liquidity and significant cash reserves, it takes more than just plowing cash into a bank account. It's a unique structure called the "Three-Bucket Cash Reserve System." This system not only ensures that you'll have enough readily available cash that's safe and secure, but it will allow you to earn a fairly decent overall rate of return on your money as well.
What I also like about the Three-Bucket System is that I could do it in stages. Once I got started, the reserves became such a comfort and strength that I truly wanted more. If I dipped into my reserves at all, for anything, good or bad, I was extremely anxious to get the money back into the system. I was addicted to the security and flexibility it offered me.
Start with the first bucket to build some confidence, momentum and better habits, then graduate to the other buckets. It's easier than you can imagine once you get started.
1. One Month's Personal Living Expenses
Of course, this one month's amount is going to vary dramatically from one person to another. Moreover, monthly living expenses can also fluctuate dramatically from one month to the next depending on what's going on in our lives. This unpredictability is what causes some people to stop right here and give up dead in their tracks. Don't do it!
To help calculate this amount and create a new mentality to saving and spending, only count your essential living expenses. Then take your total expenses for the year (as best as you can estimate them) and divide that number by 12. This monthly average accounts for the ups and downs in monthly expenses. Save that average amount each month and you'll get the bucket going.
This money should be in a separate bank account or even a separate bank from your other accounts (if your self-discipline is lacking a little). Here's the statement you may have trouble with: Don't worry about interest rates or investment factors. People are so trained to chase interest rates that they hesitate to simply have money available. Interest rates on liquid accounts are very low these days. Sure, two percent beats one percent, but just having available cash is more important. Just make sure it's accessible and liquid in the event of an emergency.
2. Two Months' Living Expenses
This is an additional two months' worth of take-home pay in your savings and is on top of your first bucket. Thus, you'll now have a total of three months of living expenses in reserve. Again, you can use an average of what this expense may be, and I encourage you to be generous. Fault on a little extra, rather than less -- you won't regret it. There's an ingenious way to slowly build these accounts: Deposit the distributions from your business into savings first before paying your living expenses. This bucket will be in a savings account similar to bucket one. Again, don't worry about interest or rates of return. This bucket has a far bigger purpose and benefit.
3. The "It Depends" Reserve
At this juncture, with one month's essential expenses pouring into the checking account monthly and two months net take-home pay in your savings, we now need to think about how much more money is enough to keep in your third cash reserve bucket. The amount of money you keep in this bucket will vary widely from person to person. That being said, it needs to be a significant amount. In fact, as an entrepreneur, this bucket will need to be much bigger, like six to nine months. This bucket may be funded with cash value life insurance -- there will be a death benefit, and the cash asset will be protected and guaranteed no matter what happens to your health.
Whatever your dollar amount needed to be to fill all three buckets, they need to be completely full before you save and invest for your retirement. In order to succeed in this process, these buckets need to be taken seriously.