Emergency Fund Options

Yesterday several of my fellow bloggers had some interesting comments on Emergency funds, including Advanced Personal Finance and Frugal Dad. Please take a look at both of these posts, as they show two completely different but equally valid views on emergency funds.

From my perspective I think and emergency fund should be personalized to each family. Therefore I’d like to discuss a few of the more common options worth considering and the good and bad points of each. I also recognize that some people have split their emergency fund into several buckets, including “opportunity funds”, “money to be invested funds”, etc. For the purposes of this discussion I’m going to lump all of these together into the emergency fund assets, because should an emergency occur I would argue that these funds would be used for necessities.

The first question to be answered is: What kind of emergency am I preparing for? Is it a job loss, a major car problem, or an unexpected issue with your home that requires an immediate repair? You don’t need to create a list of every possible problem and freak yourself out, but it will help if you know:

• do you expect to need cash or could you write a check for the emergency? For example, most plumbers in NYC only take cash. You’d be in trouble if you couldn’t scrape up $100-$200.
• do you need to pay immediately or do you have a few days to pay a bill? I’ve never had this happen, but I’m assuming you could write a check for a new air conditioner or heater if necessary.

Approach #1: Keep things simple and accessible

The most simple approach to an emergency fund is probably the fixed dollar amount version in a local bank, similar to what Frugal Dad recommends. Dave Ramsey recommends starting with $1000, and I think that is a reasonable goal. Where you store the funds depends on how neurotic you want to be and requires that you think through what types of emergencies could occur? If you go with a local savings account, you’ll have access to CASH immediately if needed through and ATM or through a bank teller (ATM’s may limit your daily withdrawal amount though).

Alternatively you could put your emergency fund in an internet savings or checking account. Since these funds (hopefully) will go untouched for years at a time I would recommend a savings account over a checking account. You’ll earn more interest, hopefully enough to keep up with inflation, and you’ll have ATM access to the account as well.

Note that most banks and mutual fund companies will allow you to perform an ACH, which is an automated transfer of funds between accounts at different institutions. These take 2-3 business days to occur. Alternatively you can also wire funds, which is instantaneous but typically costs $25-$50 or more. This option should be used sparingly, but if you really needed to move money quickly from an internet bank to a local bank you could wire the funds. You might consider setting up this capability with your various banks in advance so that you are clear on what the costs and requirements are before you really need to use this option.

Approach #2: keep things simple but a little less accessible

I personally keep my emergency fund in a Vanguard money market account. You’ll need to reach the $3,000 minimum to open an account, but it has check writing privileges (checks must be over $100) and earns an interest rate that usually puts this fund in the top 10% of all money market accounts due to low fees. The downside to this option is that you can’t get cold hard cash out of the account on a moments notice. I have a separate checking account I use to pay my regular bills, so if I needed a small amount of cash I have that account to use.

Approach #3: use credit

As the Advanced Personal Finance post mentioned, you need to make sure that you have the discipline to pay off the bill in full when it arrives, otherwise you’re going backward on the personal finance journey. I’m not a big fan of using credit, but I am disciplined enough to pay off the bill when it arrives (I wasn’t always this disciplined, but I am now!). I do this with several of my monthly bills and expenses as well, and have been paying off my monthly credit card bills regularly for a while now.

You could also use a HELOC in the same way, but I don’t have one and probably wouldn’t go this route personally.

Approach #4: use your taxable investment accounts

Most people would shy away from this choice based on the argument that “you may have to sell your investments at the worst possible time” or “you’ll have to pay taxes on the gains if there are any”. These arguments have merit but I have a better counter argument: “You many never need to use your emergency fund, especially if you are saving a good sum of money regularly”. If you don’t need your emergency fund often, then you’ll be missing out on decades of potential growth.

I would not recommend keeping your entire emergency fund invested in stocks or bonds, but I do understand that some people might consider this approach if the rest of their financial situation is in good shape. Here is one hypothetical example of someone who might consider this approach:

• stable job. No job is truly stable, but a marketable skill set and good work ethic can help bridge any income gaps that might occur.
• sizable taxable investment accounts (i.e. a 20% market correction wouldn’t drop his/her account below the desired emergency fund amount)
• healthy family
• reasonable regular savings. Even if you want a “full 6 months of expenses” emergency fund, this size of an emergency fund is probably intended to cover a job loss. Most other emergencies would cost much less than 6 months of expenses. Therefore you could keep a much smaller amount in a liquid, safe savings account or money market account and potentially invest the remaining funds elsewhere. Your regular monthly savings should be able to cover a few unexpected emergencies.

Approach #5: Roth IRA’s

You can take your Roth IRA initial investment out at any time without penalty. You’ve already paid taxes on it, so when you pull it out you don’t need to worry about penalties or taxes. You cannot remove the growth on your investment without penalty early (unless you meet the IRS guidelines for a withdrawal), but the initial investment (or investments over the years) is accessible. I wouldn’t recommend this unless absolutely necessary, because you’re losing the value of compounding and long term growth. It is an available option though.

Approach #6: regular IRA and/or 401k

I’m now straying beyond the advice published by Advanced Personal Finance into an even more aggressive approach. This is an approach recommended by the author of a book I read a long time ago (I wish I could remember the author, but I recall he’s a pretty high-end kind of CFP). His viewpoint was that the only thing that constitutes an “emergency” is something that lowers your tax bracket. Extended job loss, large medical bills, etc. In this case, although you would have to pay a 10% penalty and taxes on the amount you take out, you would be in a lower tax bracket which would somewhat offset these costs. This methodology also forces you to stop and consider whether you REALLY need to access these funds.

You might also have some after-tax contribution to regular IRA’s. This is something I don’t have any experience with, so if this applies to you I would recommend speaking with your tax adviser on the implications of withdrawing funds in this situation. I’m not sure of the rules, but I’m sure it will be messy.

Which approach is best for you? That’s your call, because an emergency fund is a personal thing. You might need or want a much larger or smaller cushion than someone else. Here are some of the factors that you might consider:

• Do you have a steady income or does it fluctuate (seasonal, sales, odd bonus schedule, etc)?
• Are you single or do you have a large family to support?
• Are you the sole breadwinner of the family or are you a dual income household?
• If you are a dual income household, can you meet your minimum expenses with EITHER ONE of those two incomes if you had to?
• Are you more concerned about a job loss (big, long-term expense) or something smaller (car problems, misc. medical bills, etc)?
• Are you conservative or aggressive in your investing?
• Do you have taxable investments that you could potentially tap?
• Do you have a highly specialized job such that finding a new job would be time consuming and difficult?
• Do you have family that could help you financially if necessary (or watch the kids if you become ill for a little while, etc)?
• Any big expenses coming up that you know of? Are you driving an 18 year old car or are you planning to have another child in the near future?
• Is the food and gas inflation killing your budget or causing you to go into debt? I don’t consider these things “emergencies”, but they do remove your ability to save and insulate yourself from other unexpected events.

As for me, I use Approach #2, but I frequently think about combining this will Approach #4 quite often. If I did invest part of my emergency fund I would probably setup a separate account for it and invest in something in the average to conservative risk category. Perhaps a total market bond fund or a balanced fund might work, but I’m conservative and would want to minimize downward value fluctuations as much as possible while still beating inflation.

Please see the terms and conditions of this website. This post contains my personal viewpoints and thoughts, and does not constitute legal, financial, or other professional advice. Your situation is different from mine, and you are responsible for your own decisions and the results of those decisions. If you are in need of need professional assistance I recommend that you consult a Certified Financial Planner, preferable one who works on a fee-only basis.

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