How Should You Invest Your Emergency Fund?

Having discussed why having an emergency fund is a good idea and how big an emergency fund needs to be, I’d now like to talk about investments suitable for an emergency fund.

Generally speaking, some part of your emergency fund needs to be in a liquid, readily accessible investment whose value does not fluctuate much.  An emergency fund invested entirely in your employer’s stock would therefore be a really, really poor choice.  Typically, emergency funds are invested in savings accounts, CDs, money market accounts (taxable or tax-free), or Treasury bills/notes/bonds.  Where bank deposits are used, they should be FDIC-insured.  These types of investments generate low returns, but are very likely to be readily accessible in the event of an emergency.  Depending on your situation, some part of your emergency fund might also be held in longer-term securities.

The fact that cash produces such small returns these days – 3 to 4% at best – probably frustrates a lot of people when they think about emergency funds.  Why keep money tied up in low-yielding cash accounts when you could have it invested in stocks or mutual funds?

The problem with having very little money in liquid form is that you often pay one or more penalties when you have an emergency.  As I discussed in my first post, if you must resort to credit to pay for an emergency expense you’re at the mercy of credit card or HELOC market rates, which can increase over time.  If you’re forced to sell assets to pay for an emergency expense, you often must realize a capital gain, which forces you to pay additional income tax.  If you must sell an asset at a time when its value is temporarily depressed, you’re forced to forgo its future appreciation.  Worse yet, if you must use assets from a qualified retirement account like a 401(k), you have to pay ordinary income tax and probably a penalty tax in order to get funds to make ends meet.

If you have an emergency and no liquid capital, you’re often forced to resort to a “distressed” asset sale in order to keep afloat.  Something people tend to forget is that there’s a big difference between a guaranteed return of 3.5% on a CD and the possibility of a 9-10% yield on a stock or mutual fund.  A stock’s value can drop precipitously in a relatively short time, and even a mutual fund’s price can drop 10-20% in a matter of weeks.  This is why it is usually wise to have some portion of your emergency fund in ready cash.

The question of whether one’s emergency fund should be invested entirely in cash vs. a blend of investments depends on several factors.  The desire to have a good return on your capital needs to be weighed against other considerations.

How big is your emergency fund?
If your fund is $10,000, there aren’t a lot of options available to you, and wouldn’t make much sense to spread that amount of money among several different accounts.  An online bank account might be your best option, or you might put half of the fund into a regular account and half into a CD with a maturity of perhaps three months (in order to get a slightly higher net to return).  In the event of an emergency, there’s a good chance that you could spend the ready cash first and then, if needed, cash out the CD as it matures.  In the worst case, you could pay the interest penalty if you have cash out a CD prior to its maturity date.

On the other hand, there are households that require a $100,000 emergency fund.  In that situation, perhaps a month’s expenses could be kept in cash.  The rest could be divided up into one-year CDs, each maturing in a different month.  This would increase the return received and if interest rates increase the money can be “rolled” into new CDs to boost the rate of return.  This would still be a conservative approach, though.

Have you reached your emergency fund target goal, or are you just getting started?
If you’re just starting to save and the amounts involved are relatively small, your savings options are again rather limited.  If you’re in the early stages of building an emergency fund, you probably want the funds to be in the most liquid of investments in case they’re needed.  If your fund is 100% funded, you may have enough money to spread among different options.  Ideally, you’d like to have a few “layers” – a lower-yielding but readily accessible chunk of money for the near-term, and some potentially higher-yielding investments that can be accessed in the event that you suffer a longer-term shortfall.  You might, for example, want to have a couple of months’ spending in an online savings account, a couple more in CDs, and a couple more in something that you hope you don’t have to tap, like a Roth IRA invested in stocks.

What is your tax bracket?
If you’re in one of the highest tax brackets and have decided to keep some of your emergency fund in a money market fund, it might make sense to use a tax-free money fund.  If you live in a high-tax state and can find a money market fund specific to your state, so much the better.  For example, if you life in New York there are money market funds that invest in short-term, high-quality New York municipal securities.  Income from the fund is exempt from federal income tax, New York personal income tax, and New York City income tax.  If your net marginal tax bracket is high enough, a fund like this might be an attractive alternative to a regular taxable money market fund.

Your marginal tax rate is the rate you pay on your next dollar of income; it’s usually what people refer to when they speak of your “tax bracket.” Suppose you’re in the highest federal bracket (35%) and your state income tax rate is 5%; your total marginal tax rate is 40%.  In order to compare a particular tax-exempt fund to a taxable fund, take the tax-exempt fund yield and divide it by (1 minus your marginal tax rate).  If the tax-exempt yield is 1.45%, this would be comparable to a taxable yield of about 2.4%.  It’s not much of a yield; it’s actually lower than current inflation.  But if you need very liquid money, it’s a good “top” layer.

If you’re in a high tax bracket, one place to put a deeper layer of your emergency fund might be tax-exempt municipal bonds issued by your state.  Although municipal defaults can happen, they are rare.  Depending on market conditions at the time you buy, your after-tax yield from this kind of bond could be substantially higher than a CD.  The catch: if you do need to sell the bond prior to its maturity in order to cover an emergency expense, there’s no guarantee that you’d recover your original investment.  Bond prices go down as well as up.

How risk-averse are you?
If you have a really high tolerance for risk, you could view your 401(k) or other defined-contribution fund balance as the last-ditch part of your emergency fund – the deepest layer.  If you determine that you need a six month reserve, you could plan for the final two months to come from your 401(k) fund.  Even so, assuming that you’ll be able to borrow the money from your 401(k) isn’t a great idea: that won’t be an option if you lose your job.  I’ll have more to say about this emergency funding option later.

Having a Roth IRA as one of the inner “layers” of your fund is a less-risky approach.  If you do have to drain a Roth you’d lose the benefit of that part of your retirement savings, but you wouldn’t take a tax hit as long as you only withdraw prior contributions (not earnings).  You’d probably have most of this money invested in stocks; in that case you’d bear the risk that the emergency came at a time when stock prices were depressed.

If you conclude that you really need a large emergency fund – say, a year’s worth of expenses – but you’re uncomfortable keeping so much money in cash, you might also consider using assets in a non-retirement account (e.g. stock mutual funds) as your deepest layer of emergency fund money.  With this kind of arrangement, if you actually experienced a job loss, you’d want to review all your assets.  If at that point you’ve experienced big gains in your taxable account, that might be the time to realize some of them while they’re still gains rather than waiting to see how long you need the money.

This is an area where you should think about balancing your risks.  If you have a job that’s at high risk of a layoff, putting your emergency fund money in risky assets is rather like “betting the farm.” If you have a couple of incomes, that might put you in a good position to take a little more risk with your emergency fund.  This is an area where your tolerance for risk and your assessment of how likely you are to need the money must come into play.

What other emergency resources do you have?
If you have sufficient equity in your home, it’s a good idea to apply for a HELOC (home equity line of credit) when things are going well and keep it available and unused.  I don’t think a HELOC should be the first line of defense in an emergency, but it could be alright to use as a “deep” layer in your emergency fund strategy.  Keep in mind, though, that if you’re not able to pay your bills and you resort to a HELOC, you’d better have a reason to believe that you’re close to the end of your emergency.  Otherwise, you stand to lose your home in the bargain.  You also need to take care that you have a sufficient equity reserve; lately some banks have been summarily freezing HELOCs out of fear that the equity behind them has dried up.

If you own a life insurance policy with cash value, you could take a loan from the policy in a pinch.  This won’t be an option for many people, because most people won’t find it in their best interest to own a cash-value insurance policy.  Still, it’s a resource that can be tapped if you have it.

Illiquid assets aren’t a lot of help when you have an emergency.  For example, if you have to sell a piece of real estate in order to raise money for living expenses, you usually need a large lead time.  There are often expenses associated with selling real property, and if the real estate market is weak (as it is now), you might not even have a net gain.  In practice, selling real property in order to raise cash is a last resort; it should not be part of your emergency plan.

Funds Formerly Useful for Emergencies
Not so long ago, short- or ultrashort-term bond funds were though of as safe places in which to put emergency funds.  These funds provided enhanced returns over money market funds, but many of them, until recently, were investing in bonds backed by subprime or other mortgages.  Some big-name (Fidelity, Schwab) ultra-short funds experienced double-digit losses when the subprime crisis hit.  Many conservative investors had formerly considered these funds to be great investments.  Watertown (MA) Savings Bank, a rather conservative local bank, recently reported losses of almost $16MM from money parked in an ultrashort-term bond fund.  Investors who previously had emergency fund money parked in these funds are not happy campers this year.

Most of these funds have now fled to high levels of cash, which has stopped the bleeding but also insures that yields won’t be too impressive.

Objections to Emergency Funds
I need to acknowledge that there’s a school of thought that says that it’s unrealistic to set up an emergency fund and that you shouldn’t bother trying.  This is as good a place as any to respond to that argument.  Jonathan Clements, who used to write for the Wall Street Journal, is (in my opinion) the most eminent proponent of this idea.

Although I have tremendous respect for Clements, I disagree with him somewhat on this point.  His argument is that saving for emergencies will prevent most people from saving for retirement.  Instead, he argues that you should plan to tap your Roth IRA, sell taxable investments, or borrow from your 401(k) when you have an emergency.  I don’t have a problem with the first two ideas, but I balk at the third.

My problem is that if you borrow from your 401(k) and then lose your job, you must either pay back the loan within a fairly short time – 60 days or so – or else the loan is treated as a withdrawal and you must pay income tax on it.  If you’re under 59 ½, you must also pay a 10% penalty.  Moreover, even if you don’t lose your job, you pay back the loan with after-tax money and get taxed on the money a second time when you withdraw it during retirement.  So if you have to pull the trigger on this solution to pay for a new roof and then you’re hit with a layoff, you get whacked twice as hard.

Let me offer a quantitative example; if you don’t like my assumptions, calculate your own.  Let’s say that you have a $15,000 emergency fund that is yielding 3.5% before taxes.  Let’s say that if you invested it in equities instead, you had a decent chance of making 9%.  We’ll ignore the fact that the return on equities is not guaranteed and that you might instead lose money over a period of a year or two.  That means that if you went with the low-yielding, liquid option, you’d be paying an “opportunity cost” of 4.5%, or $675, per year.

Compare this with a situation where you’ve put all your savings into a 401(k) fund except for $5,000 that you managed to put into a Roth IRA.  Since I’ve seen several 401(k) plans where there is no employer match, let’s say your 401(k) is one of those.  Suppose you lose your job and need to tap $15,000 to stay afloat until you get another job.  You can take $5,000 out of your Roth tax free if conditions are right.  The other $10,000 must come from your 401(k) plan.

The first bit of bad news is that you need to take out more than $10,000, because you must pay income taxes and a 10% penalty on the withdrawal. As it happens, you’re in the 15% marginal tax bracket, but taking the money out of your 401(k) pushes you into the next bracket at 25%.  You also have to pay state income tax on the withdrawal, so you’re looking at taxes of 40%.  You have to withdraw $16,667 in order to have $10,000 to spend after taxes.  You can’t do it as a loan, because you can only take those while you’re working.

Overall, this doesn’t sound like a better deal to me than paying $675 a year for what amounts to insurance.  Admittedly, the picture would not be so bad if you didn’t lose your job but instead had to take a loan for some other reason.  However, it doesn’t make sense to me that one’s emergency plan should depend on having a best-case scenario.

I agree that if your employer provides a great match for your 401(k) contributions, that changes the picture.  If you get a 100% match for your contributions, that would cushion the blow if you have to tap your retirement funds for an emergency.  In that situation, if you must choose between liquid emergency funds and a 401(k), choose the 401(k), but remember not to put all your 401(k) investments into illiquid investments or company stock because those could be down in value at just the moment when you need to make a withdrawal.

Hopefully you can see that there’s room for creativity in the investment of an emergency fund, and the proper blend of investments will depend on your own personal circumstances.  There’s no one-size-fits-all combination of investments.  The key thing to remember is that, as always when you invest money, you need to think about the risks associated with each investment.  People who thought not too long ago that ultrashort bond funds couldn’t lose principal were not paying attention to this rule.

As I mentioned in yesterday’s post, for the present time some tax-free money market funds are sporting unusually high yields.  This may not last for more than several weeks, but for the present such funds are another place to consider for emergency funds.  Make sure to stick with one of the major mutual fund families when you select a fund.

About the author

Thomas Fisher, CFP®

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