Emergency fund

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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. [1] Emergency funds should be invested in a highly liquid, low risk vehicle (e.g., money market, bank savings account). [note 1]

The goal of the emergency fund is to provide a cushion of liquidity [2] 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 and pay 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.

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:

  1. Three months of expenses in cash (bank account or money market fund)
  2. The next three months of expenses in CDs with the option to cash them in for three months of interest
  3. 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]

Cash emergency fund vs line of credit

Some people view various forms of credit (particularly HELOCs[3]) 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 Credit lines can often be withdrawn with little or no notice, and some emergencies which require drawing on the emergency fund may also cause a creditor to question your ability to repay.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.[4]

It is also possible to withdraw penalty-free (but not tax-free) from a traditional IRA for certain excepted emergencies and major life events.[5]

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.[6]

See also

Notes

  1. 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."
  2. Johnson & Widdows define three levels of potential emergency fund assets:
    1. Quick— assets held in savings, checking and money market accounts.
    2. Intermediate— quick assets plus CD’s and savings certificates.
    3. Comprehensive— intermediate assets plus the value of stocks and bonds.

References

  1. 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
  2. Liquidity, on Investopedia
  3. Home Equity Line of Credit, on Wikipedia
  4. 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.
  5. See IRS Publication 590.
  6. 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.

External links