When most people build an emergency fund, they seem almost resigned to the fact that they will earn less than interest on their money. Most experts recommend putting emergency savings in a savings account, although even a “high-yield” savings account is unlikely to pay more than 1 percent annually in a low-rate environment. This may not be enough to even keep up with inflation.
Start with a High-Yield Savings Account
Savings accounts are generally used for emergencies because the money is liquid and accessible, allowing you to quickly transfer funds to your checking account or even withdraw them as cash from an ATM. They may also be one of the safest places for your money: savings accounts are insured by the Federal Deposit Insurance Corporation (FDIC), and there is no risk of losing money if the markets decline, as long as you stay within the insured limits.
But that doesn’t mean you should keep all your money there. While a good emergency fund should cover three to six months of living expenses, the savings account portion of the emergency fund may only contain enough savings for three to four weeks of expenses. This can cover your short-term needs, and if you need cash quickly, you can access enough money to tide you over until you can transfer funds from other accounts.
Be warned of some issues that can arise with high-yield accounts: check for minimum balance requirements and any fees if your balance falls below the minimum. Ensure that the interest rate is a permanent rate, not a promotional rate that is good for a short time. Make sure that the funds are accessible and that you don’t have to wait to transfer them. Check if the number of deposits, withdrawals, or other transactions on the account is limited, or what the fees are if you exceed them.
Add a Taxable Investment Account
Three to four weeks of expenses is not enough for an emergency fund. You can enhance your savings with the help of an investment account, which can offer you potential returns higher than those of a savings account. Use a taxable account instead of a retirement account like an IRA, so you can withdraw funds without incurring penalties. Invest a specified amount in a total market index fund, and as the market rises, your emergency fund will increase. If you invest regularly, such as monthly, the account will continue to grow.
Of course, the big risk with this approach is that the market might be declining when you need cash. While markets always rise over the long term, in the short term, you may end up with savings below your comfort level. And if you withdraw some of your principal along with your earnings, you will lock in losses and miss opportunities that follow a market correction.
Due to this risk, you need to tolerate some emotional risk if you plan to add an investment account to your emergency fund strategy. Furthermore, you can mitigate some risks by using bonds and index funds in the taxable portion of your emergency fund, thus reducing your exposure to market fluctuations.
Finally, remember the tax implications of selling investments in a taxable account. If you have an emergency and need cash quickly, you may have to sell investments at a loss, but the good news is that you can at least claim a tax deduction for that loss. On the other hand, if you sell them for a profit, you will likely have to pay capital gains taxes. Focus on selling stocks that you have held for more than a year so that you will be taxed at a more favorable rate.
Use
Using a Roth IRA as an Emergency Reserve Fund
If you’re eligible and investing in a Roth IRA, it’s possible to use it as an emergency reserve fund. Since you contribute to a Roth IRA with after-tax dollars, you can withdraw contributions without incurring penalties. By regularly contributing, you can build your Roth IRA to be able to meet needs in case of emergencies.
However, while you can withdraw contributions tax-free, you should be more cautious when withdrawing earnings (the returns on your contributions) from a Roth IRA. Early withdrawals of earnings incur a penalty from the IRS, so make sure to stick to the money you’ve actually put in the account.
There are some exceptions to this penalty: you can withdraw earnings to pay for healthcare expenses or if you’re unemployed. Since these emergency needs are common, it may not be a bad idea to have a Roth IRA set aside.
Also, be aware that you cannot regain time spent in the market. You have 60 days to return the money if you want to ensure it stays within the annual contribution limit. It’s good to have another tax-advantaged retirement account like your 401(k) and avoid touching it altogether. You don’t want to jeopardize your future for a today’s emergency.
Adjusting Your Emergency Savings Plan as Needed
When using this strategy, it’s important to ensure that you are operating within your comfort level. You might keep three to four weeks’ worth of expenses in your savings account, and your taxable investment account can hold six months’ worth of additional expenses. Keep your Roth IRA in the background for the big things “just in case.”
If having more than 80 percent of your emergency fund in the market makes you anxious, you might feel it’s better to keep two or three months’ worth of expenses in savings before putting money in the taxable investment account. Additionally, you also want to ensure your retirement saving plan works well with your emergency fund strategy. You don’t want to rely heavily on your Roth IRA unless you have another retirement account to serve as your long-term nest egg.
The Balance does not provide tax, investment, or financial advice. Information is provided without consideration of the investment objectives or risk tolerance of any specific investor and may not be suitable for all investors. Past performance is not indicative of future results. Investing involves risks, including the risk of losing capital.
Was this page helpful?
Thank you for your feedback! Tell us why?
Sources:
- Federal Deposit Insurance Corporation. “Deposit Insurance FAQs.”
- IRS. “Publication 590-B (2019), Distributions from Individual Retirement Arrangements (IRAs).”
- IRS. “Retirement Plan Transfers and IRA Distributions.”
Source: https://www.thebalancemoney.com/how-to-build-a-better-emergency-fund-4154331
Leave a Reply