By Jamie Johnson, WCI ContributorEmergency funds are critical as it’s impossible to predict when an emergency will hit, but it’s safe to say that we’ll all eventually experience one. A financial catastrophe can threaten even the most secure incomes, as was proven by COVID-19.
Even if you’re a regular WCI reader that is interested in learning strategies to leverage your income and grow your investments, it's still vital to talk about emergency funds—and to remind you that many high earners should still have one. After all, it is a financial buffer for those unexpected life events. The key is to stash your money somewhere easily accessible but where it can continue earning interest.
What Is an Emergency Fund?
An emergency fund is cash you set aside to cover unexpected financial emergencies. It’s only a matter of when—not if—you get hit with a surprise expense. Your emergency fund can protect you from the fallout of the following financial emergencies:
- You or your partner loses their job
- You get in a car accident
- You receive an unexpected medical bill
- You have unexpected home repairs
In addition to creating financial security, having an emergency fund set aside can help lower your stress. And it prevents you from turning to high-interest credit cards in an emergency.
How Much Should You Have in an Emergency Fund?
Most people recommend saving between three and six months' worth of expenses in an emergency fund. However, this only applies to your necessary expenses—you don’t necessarily need to set aside three to six months’ worth of income. Keep in mind, though. Some people, especially those who might be close to retirement or who have already made that move, increase their emergency fund to 1-2 years worth of expenses since they don't earn a steady paycheck anymore.
However, just like with life and disability insurance, the closer you get to financial independence, the less you need an emergency fund. When you reach financial independence, you don't need it at all, although you may simply call it the “cash portion” of your asset allocation.
Where Should I Put My Emergency Fund?
An emergency fund can give you peace of mind, but the downside is that it’s not earning you much money. You want to keep your emergency fund somewhere that’s accessible but still allows you to make as much interest as possible. The most important thing with an emergency fund is the return of your principal, not the return on your principal. Even so, it is nice to earn something on at least some of the money if you can. Let’s look at the eight options to consider, and realize that you may use more than one at any given time.
#1 High-Interest Savings Account
If you want to keep your emergency fund somewhere that’s easily accessible but still earning some interest, a high-yield savings account is a good choice. Most high-yield savings accounts are available through online banks, like Chime or Capital One. These accounts typically come with minimal fees.
However, online savings accounts don’t have a brick-and-mortar location you can stop by. If an emergency arises, you’ll have to transfer the cash out of your savings account. This could cause a slight delay in how quickly you receive the funds.
#2 Certificate of Deposit (CD)
Another option is to save your emergency fund in a certificate of deposit. CDs offer a fixed rate of return if you agree to leave the funds there for a set period of time. CD terms range between three months to five years, and the longer you leave the money untouched, the more interest you're paid and the higher your returns will be.
With a CD, you’ll earn a higher APY than most high-interest savings accounts. But if an emergency comes up before your CD has fully matured, you may have to pull out the money early. This will result in early withdrawal penalties, defeating the purpose of earning more interest.
One way around this is to set up a CD ladder, where you put equal amounts of cash in different CDs with varying term lengths. For instance, if you have $25,000 to invest, you could spread out your money across five different CDs, each with terms ranging from one year to five years.
As a CD matures, you’ll reinvest that money in a new five-year CD. After five years, you’ll have five five-year CDs, with one maturing each year. This strategy helps you earn a higher interest rate and will still keep your money fairly accessible.
#3 Money Market Account
A money market account is another good place to keep an emergency fund, though they aren’t as widely used as checking or savings accounts. A money market is an interest-bearing savings account you can take out through a bank or credit union.
The account may come with a debit card or checking-writing privileges, but you’ll be limited as to the number of purchases and withdrawals you can make. You’ll earn interest that’s on par with what you’d get from a high-yield savings account, but your money will be easier to access.
Money markets often come with tiered interest rates, so you could earn a higher rate if you have more money to deposit. And if you maintain the minimum balance requirements, you can avoid the fees that come with these accounts.
#4 Traditional Savings Account
Another option is to leave your emergency fund in a traditional savings account at your bank. Honestly, that’s probably the worst option on this list since you’ll earn so little interest.
However, the funds will be easy to access since they aren’t tied up in a long-term investment. If peace of mind is your primary goal with your emergency fund, you could take this route. But in most cases, it’s probably better to opt for a money market account.
#5 Roth IRA
You can keep your emergency fund in a Roth IRA. Roth IRAs come with many benefits, including tax advantages and asset protection. If you exceed the income limits, you can set up a Backdoor IRA instead.
By saving your money in a Roth IRA, you can keep up with rising inflation and earn more interest on your money. You can withdraw your contributions at any time without any taxes or penalties if you redeposit the funds within 60 days. If you miss the 60-day window, you’ll have to pay an early withdrawal penalty and taxes. Plus, once you take money out of the Roth IRA, you miss out on the investment opportunities your money would have had if it had remained in the account the whole time.
#6 I Bonds
Savings bonds can also serve as an emergency fund, at least after the first year when they are still illiquid. During years 1-5, you'll give up a few months of interest if you tap it, but after five years, you lose nothing. I bonds, which are indexed to inflation, are more like inflation-protected cash than bonds, but they can serve very well as part of an emergency fund after year 1. When inflation spikes, they're one of the best returning fixed income investments out there.
#7 Your Checking Account
Sure, it won't earn anything here, but it will be super accessible. Some people just leave part or all of their emergency fund right there.
#8 Your Safe at Home
You want liquidity? I'll show you liquidity. There's nothing more liquid than a stack of 20s in your safe at home. Many consider that a great place to keep some portion of their emergency funds, perhaps a few thousand dollars. Like your checking account, it won't earn anything, but it might be the only money you have access to in a really widespread emergency.
The Bottom Line
Your emergency fund is there to protect you from the unexpected, and with some strategic planning, you can make that money continue to work for you. If your priority is immediate access to cash, you can opt for a savings account, a high-yield account, or a money market account.
If you want to maximize the interest earned, then a Roth IRA or a CD ladder may be a better option. That way, your emergency fund will continue to work for you as it sits there.
But remember, you don't need a complex system for your emergency fund. It's not meant to be a long-term investment strategy. It's meant to be liquid, and if it earns you even a little bit of interest, you're doing fine. After all, in an emergency fund, the return of the principal will always be more important than the return on the principal.
The White Coat Investor is filled with posts like this, whether it’s increasing your financial literacy, showing you the best strategies on your path to financial success, or discussing the topic of mental wellness. To discover just how much The White Coat Investor can help you in your financial journey, start here to read some of our most popular posts and to see everything else WCI has to offer. And make sure to sign up for our newsletters to keep up with our newest content.
Regarding option #5, the Roth IRA – you can withdraw your principal/contributions without any penalty, at any time. The 60-day rule applies to Traditional IRAs, and any interest/earnings in a Roth IRA. I know this may have been written as is for the sake of brevity, but I do believe it’s an important distinction and something that does make the Roth a useful tool. For example: if you’re under 59.5 and put $5,000 into a Roth IRA and have it invested in a money market fund yielding 5%, and after one year you have $5,250, you can withdraw $5,000 tax and penalty-free (you’ve already paid taxes on this money!). If you were to withdraw the whole sum, the $250 would now be subject to an early-withdrawal penalty, but not the whole $5,250.
Thanks for the clarification.
Here’s a bit more clarification especially for those doing the backdoor Roth and then thinking those Roth dollars can count as part of their emergency fund:
To avoid a penalty, you need to wait 5 years after doing the backdoor Roth before you pull out the money you put in there via that backdoor Roth.
This could be a problem for people who do the backdoor Roth IRA instead of fully funding their emergency fund. They may end up losing some of their principal if they have to pull some of it back out shortly after doing the backdoor Roth.
This WCI article does a great job of explaining this issue:
https://www.whitecoatinvestor.com/5-year-rules/
If you have to do your Roth IRA contributions via the Backdoor Process, you probably don’t need your Roth IRA to be your emergency fund. You should have a high enough income that you can build a “standard” emergency fund in a taxable account without too much trouble.
I agree Dr. Dahle. I provided that clarification because Jamie Johnson’s article seems to suggest that backdoor Roth IRA dollars can also count as emergency fund:
“You can keep your emergency fund in a Roth IRA. Roth IRAs come with many benefits, including tax advantages and asset protection. If you exceed the income limits, you can set up a Backdoor IRA instead.”
Then Jake Kotzman commented that the principal is safe from any penalty. He’s correct as long as we’re talking about money that was contributed to the Roth IRA without doing the backdoor process or any other conversion.
I saw an article recently but can’t find it, about parking cash in Vanguard treasury ETFs. That might be a pretty liquid place to park cash, with appreciation that can at least keep up with inflation.
or maybe it was a fed money market fund! LOL!
https://www.mymoneyblog.com/why-vanguard-money-market-funds-are-still-the-best.html
PS. I-bonds suck. Not only for their current, relatively low yields, but the website is horrendous. I had a big pile of cash there and I forgot my password. The process to reset it involved endless questions from an agent, and some of the questions I could only answer if I had access to my account! Anyhow, finally got in, and cashed all of it out. It actually deposited into my bank account pretty quickly though, so that was good.
PPS! I got the original link above from a Finance Buff email. Here’s a good article by Harry Sit… https://thefinancebuff.com/goodbye-banks-credit-unions.html
I don’t mind the current low yields (inflation is low again) and I can live with the crummy website (but share your concerns.) I think we’re about done with them though just because of the low contribution amounts. Once your wealth gets to a certain amount, purchases of $10K or even $30K a year just aren’t going to move the needle.