Many people who want to build an emergency fund think that they have to settle for earning very little interest on their money. Most experts advise keeping your emergency savings in a secure savings account, but even a savings account with a high interest rate may not pay more than 1 percent APY in a low-rate environment. That may not even be enough to match inflation. — Worldculturepost
A savings account is a good component of your emergency financial plan, but it is not the only option. Here are some tips on how to improve your emergency fund strategy.
Start With the High-Interest Savings Account
Savings accounts are usually chosen for emergencies because the money is easy to access and use, allowing you to quickly transfer funds to checking or even withdraw it as cash from an ATM. It is also one of the safest places for your money: Savings accounts are protected by the FDIC, and there is no chance that you will lose money if the market crashes, as long as you stay within their allowed insurance limits.
But that does not mean you should store all of your money there. A good emergency fund should cover three to six months of living expenses, but the savings account part of your emergency fund may only contain savings for three to four weeks of expenses. This can cover your immediate needs, and if you need money fast, you can access enough money to last until you can cash out money from other accounts.
Be aware of some issues that can arise with high-interest accounts:
- Check the minimum balance requirements and any fees if your balance goes below the minimum.
- Make sure the interest rate is a fixed rate, not a temporary one that is only valid for a short time.
- Ensure that funds are easily available and that you do not have to wait to cash them out.
- Find out if the number of deposits, withdrawals, or other transactions on the account is restricted, or what the costs are if you go over them.
Add a Taxable Investment Account
Three to four weeks of expenses is not enough for an emergency fund. You can increase your savings with an investment account, which can offer you a higher potential return than a savings account. Use a taxable account, instead of a retirement account like an IRA, so that you can withdraw money without paying a penalty. Invest a fixed amount in an all-market index fund, and as the market rises, your emergency fund grows. If you invest regularly, such as every month, the account will keep growing.
Of course, the main risk with this method is that the market could be falling when you need money. While the market always goes up in the long term, in the short term you could end up with savings below your comfort level. And if you end up taking out some of your principal along with earnings, you will confirm losses and miss out on the gains that usually follow a market correction.
Because of this risk, you need to be emotionally resilient if you want to add an investment account to your emergency fund plan. In addition, you can reduce some of your risks by using bonds and index funds in the taxable investment account part of your emergency fund, which can lower your exposure to market fluctuations.
Consider the Tax Consequences of Selling Investments in a Taxable Account. When you have an emergency and need cash immediately, you may have to sell some of your investments in a taxable account. This could have tax implications, depending on whether you sell at a loss or a gain. The silver lining is that if you sell at a loss, you can claim a tax deduction for that loss. However, if you sell at a gain, you will probably owe capital gains taxes. Try to sell first the shares that you have held for more than a year, so that you benefit from a lower tax rate.
Use Your Roth IRA as a Backup Fund
If you qualify, and you invest in a Roth IRA, you can use it as a backup emergency fund. Since you make contributions to the Roth IRA with after-tax dollars, you can withdraw them without penalty. By contributing regularly, you can grow your Roth IRA to the point where it can serve as a good fallback option if needed.
But be careful when withdrawing earnings (the returns on your contributions) from a Roth IRA. If you withdraw earnings early, you will face a penalty from the IRS, so stick to the money you actually put into the account.
There are some exceptions to this penalty, though: You can withdraw earnings to cover medical expenses or if you lose your job. These are common emergency situations, so it might be wise to have your Roth IRA ready as a backup.
Also, keep in mind that you can’t recover the time the money is out of the market. You have 60 days to put the money back if you want to keep it 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 jeopardize your future for today’s emergency.
Adjust Your Emergency Savings Plan as Needed
When using this strategy, it’s important to make sure you are comfortable with it. 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 “worst-case scenario” situations.
If having more than 80 percent of your emergency fund in the market makes you anxious, you might prefer to keep two or three months’ worth of expenses in a savings account before putting money in a taxable investment account. Also, you want to make sure that your retirement savings plan is compatible with your emergency fund strategy. You don’t want to rely too much on your Roth IRA unless you have another retirement account for your long-term nest egg.
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