The EF (Emergency Fund) is one of the foundations of personal finance. The EF allows you to sleep soundly at night knowing your lifestyle and loved ones are protected. Whether it be from job loss, or an unexpected illness, having the ability to pay 4-6 month of expenses with savings is a game changer. Because of this, you want the EF to be invested in something fairly liquid – meaning, you can withdraw the funds quickly in order to pay for the emergency expense. You also want to ensure the EF isn’t invested in too risky of funds, or the money may not be there when you need it.
So you are probably wondering where you should stash this EF we speak of? Well, wonder no more! This is largely based on personal preference but we can run through some of the more common methods used.
High-Yield Savings Account (HYSA)
It is worth noting that I hate this one. Earning .6% interest in a savings account doesn’t sound fun to me, but at the same time, EFs aren’t supposed to be fun. In actuality, interest rates are variable depending on the benchmark interest rate set by the Federal Reserve. They might be .6% as mentioned above, or they could exceed 2% as witnessed a couple of years ago. HYSAs are available at TONS of banks and credit unions, and some of the best rates can be found using online-only banks. These funds are accessible very quickly, if needed. If this is your preferred route, do your research and find an institution and product that works best for you. Avoid the shady characters, as you should have some confidence in the custodian of your money!
Your Regular Checking/Savings Account
Most everyone already has a checking and savings account (or should – we know some of you conspiracy theorists try to stay off the radar, and that’s fine, too). If I was going to use a “traditional” EF, I would opt for this route due to ease of access and the fact that it would be with my everyday banking institution. With that said, the interest rate would typically be very low. In personal finance, you’re sometimes required to trade return for convenience. That is the case here.
The Mattress or Backyard
I don’t like either of these, but I can certainly understand them! Some people don’t trust banking institutions and I get that, but there are some inherent risks of stuffing benjamins in your mattress or burying gold bullion by the oak tree in your backyard. One of these risks is inflation (moreso with the cash). The mattress money will slowly devalue as inflation rises. Technically, your mattress money is getting smaller by the day. You also have the heightened risks of theft, destruction (fire, flooding, etc.), and possibly just forgetting the money is there (you can read plenty of news articles about this). Either way, this is a viable option.
To elaborate on the inflation risk associated with this, see the scenario below:
Let’s say Bob has $20k from the sale of his first home. Rather than spend the money, he wants to save for the future. It’s 1995, and Bob planned on working until 2020, so he’s going to hide that money under his mattress until his golden years approach. One problem – INFLATION! Since 1995, inflation has occurred at an average rate of 1.07%. Because of this, Bob’s $20k now has the spending power of $11,776. That’s right, over the course of 25 years Bob has lost approximately $8,224 at the hands of inflation. Crazy, right? This same concept applies to all money that doesn’t have a means of ‘outrunning’ inflation.
Taxable Brokerage Account
Some people, like me, can’t stand to see their money earn .6% interest. For these types, a taxable brokerage account is likely the best alternative. Here, you have the ability to invest in stocks, ETFs, and mutual funds. You can take as much, or as little, risk as you want. Heck, you can even buy penny stocks (not recommended, but also not financial advice). This type of account is especially helpful if you have a large balance where only a small portion will represent your EF. In emergencies, this would give you the opportunity to tax-loss harvest (TLH) or realize some gains on that penny stock pick you made 6 months ago! Either way, this is a very viable EF choice.
The Roth IRA
Traditionally, this isn’t the first place your mind travels to when talking about emergency funds. Ideally, you want to leave all retirement accounts (especially Roth as they grow tax free and are withdrawn tax free) alone until retirement. But the Roth IRA has a special provision that allows you to withdraw contributions at any time without penalty. Let’s say you’ve contributed $6k for 2019 and $6k for 2020 and your account has grown to $14k with interest. You can still access the $12k in contributions tax and penalty-free, but not the earnings. This makes the Roth IRA a very attractive EF.
Everyone’s personal finance story doesn’t read the same, nor should it. For my family, we no longer keep a dedicated EF at all. Instead, we have growing Roth IRA balances that give us a fallback. We also have very secure jobs, which contributes to our overall financial planning strategy. Maybe you have a job in an up and down industry that has 8 year layoff cycles and you feel that a 1-year emergency fund would be more suitable. That’s fine, these decisions should be based on personal circumstances and preference. Your choice should allow you to sleep well at night. There is no hard science behind this.
Long story short – assess your needs and determine what, if any, EF works best for you and your family. None of these solutions are the gold standard. In fact, at Wealthy Idiots, you can expect us to share a ton of different methods to become wealthy, and stay wealthy! Stay tuned for more!
