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By now, you all probably have read about the importance of having an emergency fund (with enough money to live off of if the need arises) invested in a very stable account. In fact, in my account hierarchy / financial prioritization order, this type of cash account ranks right near the top.
However, several aspects of emergency funds that there exist substantial differences in opinions include 1) where this money should be held and 2) what the money should be invested in. As such, today’s post will be dedicated to seeking position on these two considerations around emergency funds.
Let’s get started!
Emergency Fund Location – Where Should the Money Be Invested?
When it comes to the location of your emergency fund savings, the key is access.
We need to have access to this money within 1-2 days or so at the most if something unexpected pops up. More specifically, we need to have this easy, quick access to our money also without incurring any penalties, fees, or additional debt (like a credit card – which is the whole reason why credit cards are NOT emergency funds).
If we limit our selection to account locations with this criteria, nearly all traditional retirement accounts are eliminated, and we are left with the options below:
- Contributions (but NOT earnings) to a Roth IRA.
- Normal, taxable accounts.
While both of these account types are viable options for an emergency fund, analyzing your personal finances can provide some insight in to which is likely the better emergency fund location option for you.
Let’s start out by stating the obvious – if your income is high enough that you are not allowed to contribute to a Roth IRA, then your only option is to use a taxable account for your emergency fund. If this is the case for you, you can likely skip the next few paragraphs.
For the remaining people who ARE ELIGIBLE to make Roth IRA contributions each year, they likely to fall in to one of two categories:
- Category 1 – Folks who are fully funding their Roth IRA each year, and
- Category 2 – Folks who are NOT fully funding (or not funding at all) their Roth IRA each year.
Roth IRA’s are a very special and useful savings/investing vehicle. Along with Roth 401k’s (and maybe permanent life insurance), Roth IRA’s are one of the few vehicles that we have at our disposal to build the “tax-free” portion of our
Three-Legged Stool for Retirement.
Because of this, we want to take advantage of the Roth IRA option if at all possible.
However, as you’re likely well aware, we cannot simply fund a Roth IRA with however much we want each year. There is a set yearly (and vis-a-vis, lifetime) limit that the IRS imposes each year ($5.5k in 2013, for example). Because of these limits, it is in your best interest to begin funding a Roth IRA as soon as possible (i.e. not waiting until you build up an emergency fund in a regular taxable account to start your Roth IRA contributions).
Specifically, this applies to the location of emergency fund savings in the following way:
- Category 1 – Folks who are fully funding their Roth IRA each year.
-
If you’re already maxing out your Roth IRA each year, then you’re better off having your emergency in a regular, taxable account, so you can save your “tax-free” Leg of the Three-Legged Stool for retirement, when you need it more, and have more growth.
- Category 2 – Folks who are NOT fully funding (or not funding at all) their Roth IRA each year.
- If you’re not funding (or not fully funding) a Roth IRA each year, then you’re better off opening up a Roth IRA as soon as possible and beginning to use your contributions as an emergency fund.
- This will get you started accumulating capital to take advantage of the set lifetime limits imposed by the IRS on Roth IRA contributions.
If you’re interested in reading more about this decision process, I’d recommend the two great articles below:
Emergency Fund Vehicle – What Should the Money Be Invested In?
Having established whether it’s more logical to hold your emergency fund in a regular, taxable account or in a Roth IRA based on your personal situation, the next step is to decide what to invest the savings in.
When it comes to how your emergency fund savings are invested, the key is extreme stability/liquidity.
In other words, we want to invest in some vehicle that has close to 0% chance of decreasing in value, that does not lock up our money for a set period of time and incur fees/penalties for early withdrawals (like a CD), and gives us a competitive yield based on the stability profile.
If we impose these criteria, we are left with the following obvious options:
- Money Market Mutual Funds and Money Market Savings Accounts.
- This is what I currently utilize for my emergency fund savings.
- Bank Savings Accounts (not available in a normal brokerage Roth IRA, but may be available through Bank IRAs, like ING Direct/CapitalOne360).
- Bank Interesting-Bearing Checking Accounts (probably not available in a Roth IRA).
However, here recently in reading Oblivious Investor and some of the BogleHeads Forums, I’ve discovered that folks are using (in whole or in part) Short-Term Bonds/Short-Term Bond Mutual Funds as vehicles for their emergency fund savings.
Most likely, the reason for this is because they are trying to obtain more competitive interest rates on their savings, given the abysmally-low rates offered by money market accounts these days. For example, as of this writing, the CapitalOne 360 money market savings account is offering 0.75% APY, while the Vanguard Short-Term Bond Mutual Fund has delivered a return of 1.5% over the past year, so about 2x what the money markets are getting.
Having established that Short-Term Bonds meet the competitive yield criteria, we then need to determine if they are liquid and very stable. As far as liquidity goes, if you use one of Vanguard’s Short-Term Bond funds, they are likely to have $6-30 billion or more in total assets, meaning that you drawing out even $20,000 in emergency fund money in one day will likely not be a problem at all. So, I think Short-Term Bond Funds are fine from a liquidity perspective.
Thus, the only thing left to analyze is the stability of Short-Term Bond Funds. In a post I wrote in April 2013, I analyzed the ~20 year performance data of 5 of Vanguard’s Short-Term Bond Mutual Funds. The results are shown in the table below:
As you can see in the table above, all of these short-term bond funds are VERY stable.
- In fact, during the period from 1996-2013 (even with experiencing two financial crises in 2000-2001 and 2008-2009), the minimum return over a year-long period was close to +1%.
- Furthermore, the worst loss experienced in any one month period was only -2.46%.
Thus, I would conclude that Short-Term Bonds are indeed a suitable place for a part of your emergency fund, and maybe even ALL of your emergency fund if your total assets are fairly large.
For me personally, since my total assets are not extremely large yet, I like the idea of holding my emergency fund in a very secure, FDIC-insured, money market savings account that cannot decrease in value. This makes me feel better about taking risks in other places in the equity portion of my portfolio. However, I wouldn’t be opposed to shifting my emergency fund to short-term bonds in the future as my asset base grows.
How about you all? Do you hold your emergency fund in a Roth IRA or in a normal, taxable account?
What do you invest in with your emergency fund savings to keep it secure?
Share your experiences by commenting below!
***Photo courtesy of http://farm7.staticflickr.com/6131/5930041360_c98831f232_o.jpg
