BH Emergency Fund Strategy
My general thoughts on emergency funds.
After learning these things:
--Senior investors say, "...when we have enough (as defined by us), we don't need a dedicated EF as all of our investments become our EF".
--Forum’s preferred investing order: #1 get employer’s match---it’s free money, #2 fill your IRA---better selection, #3 fill employer’s retirement plan---maximize annual tax-advantages space, #4 begin taxable investing.
--Wiki’s topic on tax efficiency: https://www.bogleheads.org/wiki/Princip ... _placement
--Livesoft’s advice to tweak tax efficiency:
--Stocks can lose 50-90% during a crash, bonds can lose 5-15% during a crash.
--Forum's advice on time horizons and recommended vehicles to save for goals: <5 years, insured accounts; 5-10 years, safe bond fund; >10 years, safe equity fund.
--Wiki's Emergency Fund topic: https://www.bogleheads.org/wiki/Emergency_fund
--Wiki’s advice that "daily accrual" muni funds are exempt from the IRS 6-month holding period requirement to protect tax-exempt dividends. (Meaning they are as easy to sell as taxable bonds.) See "Loss on mutual fund shares held 6 months or less": https://www.bogleheads.org/wiki/Tax_los ... harvesting
--Retired investors say, "...we keep 5-years in a stable value fund to avoid selling during a down market." (To avoid SoRR (sequence of return risk)---recent forum topic).
--Forum’s advice, "Invest your time actively (in your career and family) and your money passively."
--Forum’s advice, “Live below your means (LBYM) and target a significant portion of each pay raise to retirement investing.
My EF strategy.
I was able to create my first EF strategy and tweak it as it grew.
My EF strategy as it looks today… a 3-fund portfolio, with some extra cash and bonds in tiers 1-2.
--1st-tier, 1 yr ST cash: CC, cash (ATM), checking (2 mos), savings (1 mo), mmkt (9 mos VMSXX+checks).
--2nd-tier, 3 yrs IT money: less-risky bond funds (current*: VWIUX). (Tried: CDs, savings bonds.)
--3rd-tier, growing LT money: taxable 3-fund portfolio + more-risky bond funds (current*: VWLUX, WTCOX).
--4th-tier, doomsday scenario: tax-advantaged retirement accounts.
* I followed the forum’s advice and began conservatively. I gradually changed as I learned more about investing and my ability to accept risk. I now prefer the immediate gratification of higher yields and fed+state tax benefits. (Don’t expect to live long enough to enjoy the low state-tax benefit from holding EE savings bonds to 20 years.)
Waterfall. I’ve learned that above structure works like a waterfall to create/(re)fill lower pools. How? Once you establish (reestablish) how much to keep in each pool, then new money (salary, redirected distributions, SS,…) flowing into the top pool overflows to create/(re)fill lower pools to their assigned (reassigned) level. (This assumes we live below our means.)
I believe the senior investors are correct when they advise keeping our financial life simple. But I still had the urge to chase bank teaser rates (even thought I know from experience that the rates will go away, and it's a pain to move/relink accounts afterwards). What to do?
Money is fungible.
I use ABP to replace rate-chasing 1st-tier cash. I set up ABP (automatic bill payment) plans with all of my trusted creditors and target payments to use a 2% cashback CC where I can, and ~0% checking where I must. The tax-free CC cashback makes me feel better about the imposed simplicity of NOT chasing taxable teaser rates.
I also believe I’m coming out ahead by doing this. Why? Because 2%/mo cashback tax-free is better than 2% APY taxable. And 2% APY does not exist without jumping through hoops. ABP is simpler.
This is also why my 1st-tier cash is set to be no larger than 12-months of living expenses, to ensure the math continues to work in my favor.
I use VWITX to replace rate-chasing CDs. I’m no longer interested in CDs because VWITX produces more after-tax income in the 22% fed tax bracket. VWITX is also simpler to live with: no early withdrawal penalty, no rate-chasing so no relinking accounts.
--5-year CD rates: http://www.google.com/search?q=CD+5+year+rate
--VWITX SEC yield: http://quotes.morningstar.com/chart/fun ... ture=en_US
--Current VWITX TEY (taxable-equivalent yield): 2.04% SEC yield / (1 - .22) = 2.62%
Bond funds are more risky than insured CDs---the money might not all be there when needed. What to do? Assume worst case 15% bond crash and future need for a fixed amount. I filled VWITX to 118% (= 1 / (1 - .15)) of anticipated need and stopped worrying.
Just starting out, I believe new investors should:
--Always keep 2-mos of living expense in checking---first small EF so won’t run out of money during month.
--Then begin filling the other pools. Give emphasis (not priority) to tax-advantaged accounts (pool 4).
--While slowly working to build depth to pools 1-3 (add savings, mmkt, CDs,…).
This is where the waterfall technique comes in. Add savings to checking (always keep 2 mos of livings expenses in checking) and set pools 1 (cash: checking, savings, mmkt) and 2 (cash proxy: CDs, savings bonds, safe bond fund) to be 3-6-months of livings expenses each (your choice). Allow them to be filled from the overflow from checking (salary, redirected distributions, bonuses, tax refund,…) when you rebalance accounts after the first-of-the-month account statement reconciliations.
Sidebar: chasing teaser rates. It’s your choice whether you want to chase rates on checking/savings/CDs, but I don’t believe it’s worth the effort. Why?
--It’s a lot of work to get little money, so an inefficient use of your time.
--This money is tax inefficient, is reported on Sch B part I, and taxed at your highest marginal tax rate.
--I believe banking simplicity, convenience, and low cost are more important. You can spend your time more profitably by working to advance your career, and being with your family.
Once you are maximizing all annual tax-advantaged space, and satisfied with the size of your pools 1-2, then you can begin taxable investing for retirement (pool 3).
Progress will come slowly in the beginning. But things will speed up as your career advances and you target a significant portion of each pay raise to retirement investing. And as time passes and your investments grow, you’ll find yourself reassigning an increased size to pools 1-2. This is when you’ll know the waterfall process is working for you. And pool 3 can be allowed to grow without limit.