The concept of an emergency fund is simple. Ideally, we should all have 6 months of expenses put aside in a savings account, just for emergencies. There are generally two objections to this school of thought.
Objection 1: Inflation risk and opportunity cost
From an investment perspective, emergency funds held in cash represent significant opportunity cost. In fact, some experts will tell you that six months’ of expenses is way too much to subject to the inflation risk and opportunity cost of a traditional savings account. In certain circumstances, I would agree with that. As with most things financial, the answer comes down to an individual’s personal situation.
Cash is king when it comes to emergency funds for two reasons: first, it is liquid, and liquidity needs should always be an investor’s first consideration. Second, it is virtually free of investment risk. However, depending on how much emergency cash you have and your own level of risk tolerance, you might want to consider an alternative to a traditional savings account.
Solution 1: Increase yield with a short-term bond mutual fund
Short-term bond funds invest in investment grade bonds with short maturities, typically 3 years or less. As such, they are generally lower-yielding investments than longer bonds. Short-term bond funds are less sensitive to interest rates than longer bonds, making them a more conservative investment. As a trade off for slightly higher yield, however, these funds do carry a bit more risk. Look for a fund with low expenses and shorter duration to preserve your principal.
If you need a good company to purchase a bond fund through, I suggest either Betterment
or Personal Capital. Betterment and Personal Capital are both part of an industry shift towards low cost wealth management and have recently been gaining a lot of clients.
Objection 2: Six months’ expenses is a lot of money
It’s true – half a year’s expenses represents a daunting figure for many of us. A family whose expenses are $3,000 per month would be looking at $18,000, just for emergencies. And that doesn’t include funding other goals, such as college or retirement.
One way to meet this need is to reduce the amount needed by drafting an emergency plan. The idea is that in a true emergency, expenses would be ranked in order of need, and only the most necessary would remain. A second, even complementary strategy is to combine emergency savings with another goal.
Solution 2: Combine emergency and retirement saving in a Roth IRA
If you can’t afford to max out your Roth IRA and put money aside for emergencies, consider having your Roth pull double duty. Roth IRA contributions are made with after-tax dollars, and can always be taken out without penalty. Consider bulking up your Roth contribution by combining it with your emergency savings. That way, you don’t have to feel like you’re missing out on retirement savings to save for emergencies. Any money you don’t use will be available to you as retirement income. Also, once you reach your goal for your emergency fund, you can direct your entire contribution toward your more risky retirement investments.
I’d like to point out two considerations here. It is rare that I advocate earmarking retirement money for another purpose. This solution only applies if you are unable to max out your retirement contribution and save for emergencies at the same time. Second, money that is designated for emergencies should be in a separate, low-risk investment. (like a short-term bond fund, for instance) within your Roth IRA account.
Beyond the numbers
My personal viewpoint is that emergency saving is best thought of as insurance, rather than investing. In putting aside a pool of money for emergencies, we are self-insuring against job loss, medical expenses, or unforeseen catastrophe. While there is nothing wrong with maximizing your level of protection, doing so at the risk of not being covered is counterproductive. And prioritizing other goals at the expense of emergency funding puts everything at risk.
For the longest time I broke my “Emergency Fund” into six 5 year CD’s, each at $5,000 with the online bank, Ally, and then kept $10,000 in a Ally savings Account. However, that was when the early withdrawal penalty was 60 days of interest. The math worked out that if you kept the CD for at least 4 or 5 months and had to cash out, you would still make more interest after paying the penalty then you would have if you were in the savings account for the same amount of time. I came across the strategy on another personal finance blog and I think that may be the reason that Ally has changed the penalty to a longer period. It just became too popular. My CD’s are still grandfathered in at the 3.0% rate with the 60 day penalty, so it has been fun while it has lasted. All of them expire next year so I’ve got to start looking for something outside the box that offers liquidity, security and some gain. I’m definitely a believer in using a tiered level of moderate risk for some of the Emergency Fund. I would hope to not need every single dollar in the fund on Day 1 of a crisis.
Use acorns dot com app. In the last 7 months I’ve made 4% on aggressive portfolio. Considering stock market is crappy right now.
My daughter just got her first job since graduating from college, and her 401(k) benefits don’t kick in for a year. I’ve encouraged her to put as much as she can in her Roth over the next year. Her income isn’t very high right now, so she shouldn’t owe much in taxes. She’s 22 and has decades before she needs retirement and can always access the contributions at any time. She invested $1,000 a few years ago, and it’s already worth over $1200. Even if she took out the $1k, that $200 would sit there for 43 more years. Fantastic way to save for the short-term AND the long-term.
If people are wary of keeping 6 months of funds — I am! — they should figure out their emergency budget. If the worst were to happen, how much would they need to survive with the basics. We were realistic and added some sanity savers like Hulu and Netflix.
Turns out, we don’t have quite 3 months’ worth of expenses saved. So I’m slowly beefing up our EF by $50 a month. We have bigger fish to fry right now — like $25,000 of oral surgery bills this year — so it’s not as big a priority. (I have very good job security, and my husband’s on disability.)
We also have a bunch of different accounts for savings goals. That way, in an emergency there are still savings we can use. For example, we were saving up a car fund. So when we suddenly needed a new car, we drew from that and savings rather than touching the EF.
I’m cautious about using an IRA as an emergency fund though. Since there are yearly donation limits, you could be setting yourself back by a couple of years. But it’s always good to have a few options to consider, I suppose.