An emergency fund is a cash reserve required to meet unanticipated needs for cash, such as medical bills, car or home repair, or job loss. The quantity of emergency funds is usually specified as an integer multiple of monthly expenses, e.g., three months to one year's worth of expenses.
The goal of the emergency fund is to provide a cushion of liquidity in the event of unexpected expenses or of a loss of regular income due to unemployment.
It is generally best to establish a modest emergency fund while getting any employer match to an employer retirement plan (e.g. 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] : somewhat higher return, if one is willing to put in the effort to set-up.
It might be useful to keep some real cash around for those emergencies where one does 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. Since in such a scenario you will not need all the funds at once, some investors seek to 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 embedded options which allow them to be cashed in at any time for a small penalty). I bonds (which after some period can be cashed in at no cost) 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 since the odds of needing to rely on your emergency fund for more than six months are slim, some would consider this an acceptable compromise.[note 2]
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 HELOCs) 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. One 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 several days may be needed for the fund transfer process to complete.
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 3]
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.
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.[note 4]
- Johnson, D. P. & Widdows, R. (1985). Emergency fund levels of households. In K. P. Schnittgrund (Ed.),Proceedings of the 31st Annual Conference of the American Council of Consumer Interests, 235-241.
In this paper, the authors define emergency funds as "financial holdings which are available to cover spending in the event of an emergency (income disruption) without drastically adjusting the household’s current level of living."
- Johnson & Widdows define three levels of potential emergency fund assets:
- Quick— assets held in savings, checking and money market accounts.
- Intermediate— quick assets plus CD’s and savings certificates.
- Comprehensive— intermediate assets plus the value of stocks and bonds.
- This article's Discussion tab contains the complete details - including the relevant text from IRS Revenue Bulletin 2004-33 which states:
- "...a distribution from an HSA in the current year can be used to pay or reimburse expenses incurred in any prior year as long as the expenses were incurred after the HSA was established."
- The balance in the account does not count as an asset, nor would distributions from it count as untaxed income when they are used for qualified medical expenses. Distributions not used for qualified expenses are subject to income tax (and a possible penalty) and will be counted in the adjusted gross income. Source: "2018-2019 Application and Verification Guide Chapter 2: Filling Out the FAFSA" (PDF). studentaid.ed.gov. Federal Student Aid (US Department of Education). August 2018. Retrieved June 23, 2019.
- Larry E. Swedroe, Kevin Grogan, and Tiya Lim, The Only Guide You'll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments, Bloomberg Press; 1 edition (August 2, 2010), p.18. ISBN 978-1576603666
- Liquidity, on Investopedia
- Home Equity Line of Credit, on Wikipedia
- See IRS Publication 590. For an easy-to-understand guide of the IRS's Roth IRA withdrawal regulations, see: Roth IRA Withdrawal Rules, by forum member ObliviousInvestor. and the Instructions for Form 5329.
- See IRS Publication 590.
- Refer to this forum discussion for details: Should an Emergency Fund be in a Roth. If unsure, please ask for guidance - this is use of a retirement account for a different purpose.
- IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans
- finiki: Emergency fund
- Publication 590, Individual Retirement Arrangements (IRAs), from the IRS
- Roth IRA Withdrawal Rules, by Mike Piper (forum member ObliviousInvestor)
- Your Traditional IRA is Life Insurance and an Emergency Fund, by The Finance Buff
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