Emergency fund

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An emergency fund is a cash reserve to cover unanticipated needs for cash, such as medical bills, car or home repair, or job loss. The size of emergency funds is usually specified as a multiple of monthly expenses, for example, three months to one year's worth of expenses.

An emergency fund aims to provide a cushion of liquidity in the event of unexpected expenses or of a loss of regular income due to unemployment. Emergency funds should be placed in a highly liquid, low risk vehicle (for example, a money market fund or a bank savings accounts).

It is generally best to establish a modest emergency fund while getting any employer match to an employer retirement plan (for example, 401(k) or 403b) and paying down high-interest-rate debt (such as credit card debt) before investing for longer range goals such as retirement, college expenses or a home down payment.

Placement of the emergency funds
Emergency funds should be placed in a highly liquid, easy to access, low risk vehicle with guarantee on the capital.
 * Checking account
 * Money market fund
 * (High Yield) (insured) savings account
 * Reward checking account [RCA], which offers somewhat higher return, if you are willing to put in the effort to set one up.

It might be useful to keep some real cash around for those emergencies where you do not have access to bank accounts.

Multi-tiered emergency fund
By far the most common emergency that would require dipping into the emergency fund is the loss of a job. Because you will not need all the funds at once in this case, you might have multiple tiers of emergency fund so that funds not needed for several months can be placed in short-term bonds (including CDs) to earn higher yield.

Those investment products include very short-term treasury bills, as well as CDs, which often have an option allowing them to be cashed in at any time for a small penalty. I bonds can be cashed in at no cost after a period, and so can also form a part of this second tier of emergency fund.

For instance, a multi-tiered emergency fund could consist of:
 * Three months of expenses in cash (bank account or money market fund)
 * The next three months of expenses in CDs with the option to cash them in for three months of interest
 * The next three months of expenses in a short-term Treasury bond fund. Selling these would risk incurring some loss of principal due to interest rate changes, but because the odds of needing to rely on your emergency fund for more than six months are slim, you might consider this an acceptable compromise.

A note on unemployment benefits
The most common emergency is job loss. In the United States, many workers who are laid off are eligible for unemployment insurance payments. The details regarding eligibility and the size of the benefit vary by state. An important part of your planning should be to find out the rules in your state, and try to determine if you would be eligible, and what the size of the benefit would be. In a very rough sort of way, the unemployment benefit could be about 50% of salary, up to a maximum of about $500 per week, for a maximum of six months; this implies that for many people unemployment insurance could serve as part as an "emergency fund," with a value of over $10,000.

Cash emergency fund vs line of credit
Some people view various forms of credit, particularly a Home equity line of credit (HELOC), as suitable for emergency funds; others strongly disagree. Credit lines can often be withdrawn with little or no notice, and some emergencies which require drawing on the emergency fund may also cause a creditor to question your ability to repay.

Roth IRA as an emergency fund
In some situations, a Roth IRA can be used as emergency fund. Contributions (that is, the money that you put into your Roth) can come out at any time, free of taxes and penalties. This is not true of earnings on your contributions, which are subject to more complex rules. It is also possible to withdraw penalty-free (but not tax-free) from a traditional IRA for certain excepted emergencies and major life events.

A Roth IRA is primarily intended for retirement, not to store emergency funds. You should consider the impact to portfolio allocations and potential custodial costs. There are behavioral considerations, as well. If a choice is to be made between funding a Roth IRA and an emergency fund, a Roth IRA can be used as an emergency fund in the appropriate situation.

Also consider that funds in investment accounts (Roth IRA) are not immediately available. Check with the fund provider, as you may need several days to complete the fund transfer process.

Health savings account as an emergency fund
A Health Savings Account (HSA) can be used to pay for unexpected medical expenses tax-free, as long as they are qualified. Normally, non-medical (and unqualified medical) distributions from an HSA would be taxed as income and assessed an additional 20% penalty.

However, if medical expenses are qualified, incurred since the establishment of the HSA, paid out of pocket, and appropriately documented, they can be reimbursed in a future year. So a running tally of reimbursable expenses can be kept, allowing tax-free withdrawals along the same lines as Roth IRA contributions.

Note that this strategy puts the shorter-term need for liquid, low-risk emergency funds in opposition to the longer-term tax savings of appreciated assets in the HSA. If only part of the HSA is considered part of the emergency fund, the two parts (emergency fund and long-term growth) of the HSA should have different asset allocations and be carefully tracked.

As with using Roth IRA contributions for emergencies, any withdrawals would permanently reduce tax-advantaged 'space'. For that reason, and because HSA funds might not be available as quickly as bank accounts, HSA funds should probably only be considered a 'later tier' of the total Emergency Fund.

Additional considerations
If you are applying for financial aid for college or grad school, HSAs are excluded as income in the FAFSA® (Free Application for Federal Student Aid) form.