It’s Time to Build a Better Emergency Fund

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When most people set out to build an emergency fund, they seem almost resigned to the fact that they’re going to earn almost no interest on the money. Most experts recommend parking your emergency savings in the safety of a savings account, although even a “high-yield” savings account is unlikely to pay much more than 1 percent APY in a low-rate environment. That probably won’t even be enough to keep pace with inflation.

While a savings account should be part of your emergency financial strategy, it’s not the only way to make such a strategy work. Here’s how to build a better emergency fund.

Start With the High-Yield Savings Account

Savings accounts are generally used for emergencies because the money is liquid and accessible, allowing you to quickly move funds into checking or even withdraw it as cash from an ATM. It’s also arguably the safest place for your money: Savings accounts are insured by the FDIC, and there’s no risk that you’ll lose money if the market takes a dive, as long as you stay within their allowed insurance amounts.

But that doesn’t mean you should keep all of your money there. While a good emergency fund should cover to three to six months’ worth of living expenses, the savings account portion of an emergency fund may hold only savings comprising three to four weeks’ worth of expenses. This can cover your short-term needs, and if you need money quickly, you can access enough money to last until you can liquidate money from other accounts.

Beware of a few issues that can come up with high-yield accounts:

  • Check minimum balance requirements and any charges if your balance falls below the minimum.
  • Verify that the interest rate is a permanent rate, not a promotional one that's only good for a short period.
  • Make sure funds are readily available and that you don't need to wait to liquidate them.
  • See 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’ worth of expenses isn’t enough for an emergency fund. You can augment your savings with the help of an investment account, which allows you to see a higher potential return than with a savings account. Use a taxable account, rather than a retirement account like an IRA, so that you can withdraw money without incurring a penalty. Invest a set amount in an all-market index fund, and as the market gains, your emergency fund grows. If you consistently invest, such as on a monthly basis, the account will continue growing.

Of course, the big risk with this approach is that the market could be on the downswing when you need money. While the market always goes up in the long run, in the short term you could end up with savings below your comfort level. And if you end up withdrawing some of your capital along with earnings, you’ll lock in losses and miss out on the gains that tend to follow a market correction.

Because of this risk, you need good emotional risk tolerance if you plan to add an investment account to your emergency fund strategy. On top of that, you can limit some of your risks by using bonds and index funds in the taxable investment account portion of your emergency fund, thereby decreasing your exposure to market volatility.

Finally, keep in mind the tax implications of selling investments in a taxable account. If you have an emergency and need the cash right away, you might have to sell investments at a loss, but the good news is that you can at least realize a tax deduction for that loss. On the other hand, if you sell for gains, you’ll likely have to pay capital gains taxes. Focus on selling first shares you’ve had for more than a year, so that you are taxed at a more favorable rate.

Use Your Roth IRA as a Backup Fund

If you are eligible, and you invest in a Roth IRA, it’s possible to use it as a backup emergency fund. Because you contribute to the Roth IRA with after-tax dollars, you can withdraw contributions without penalty. When you contribute regularly, you can build your Roth IRA to the point where it can make a good stop-gap if needed.

However, while you can withdraw contributions tax-free, you have to be more careful when withdrawing earnings (the returns on your contributions) from a Roth IRA. Early withdrawals of earnings come with a penalty from the IRS, so make sure you stick to the money you actually put into the account.

There are some exceptions to this penalty, though: You can withdraw earnings to pay for medical expenses or if you’re unemployed. Since these are common emergency needs, it might not be a bad idea to have your Roth IRA waiting in the wings.

Also, realize that you can’t get back the time the money spends out of the market. You have 60 days to put the money back if you want to make sure it stays within the annual contribution limit. It’s a good idea to have another tax-advantaged retirement account like your 401(k), and avoid touching that at all. You don’t want to risk your future for today’s emergency.

Tweak Your Emergency Savings Plan as Needed

When using this strategy, it’s important to make sure you work to your comfort level. You can keep three or four weeks’ worth of expenses in your savings account, and your taxable investment account could have another six months’ worth of expenses. Your Roth IRA is in the background for the “just in case” big stuff.

If having more than 80 percent of your emergency fund in the market makes you nervous, you might feel better keeping two or three months’ worth of expenses in a savings account before putting money in a taxable investment account. Additionally, you also want to ensure that your retirement savings plan works well with your emergency fund strategy. You don’t want to lean heavily on your Roth IRA unless you have another retirement account for your long-term nest egg.