An emergency fund is basically a reserve of money you set aside in case of an emergency such as being unexpectedly fired from your job or your car’s transmission failing. Many people recommend analyzing your monthly income or cost of living and then aiming to have three, six, or even eight months of funds on hand. However, when you are starting out building the fund, you should first aim for one month of funds, then two, and so on. For example, if your cost of living is $3,000 per month, you would want $18,000 in your emergency fund to cover six months of expenses. Then, you would not be scrambling to pay bills or find another job. This flexibility allows you to reduce stress and make better long-term decisions about your next employer.
Why have an emergency fund? The emergency fund is the first step toward financial independence. Credit card issuers like to tout credit cards as an “emergency” lifeline, but this only encourages you to end up not being able to pay the balance back and being subjected to extraordinary interest rates that are often as high as 28% per year (annual percentage yield).
The emergency fund is liquid, being quickly available if needed. You would not want to consider a car or piece of real estate as your emergency fund, because these are illiquid assets—the time and effort to sell these items could be substantial. In a job-loss situation, you don’t want to have to sell illiquid assets at a large discount just to acquire cash quickly. When people discover financial literacy, they often have a zero or even negative net worth. Establishing the emergency fund is the first step toward a financial turn-around for such individuals.
If you are carrying a balance from month-to-month on credit cards, it is probably best to establish a small emergency fund of one month’s expenses and then aggressively pay down your credit card balances. This is because you are getting an instant 28% annualized return on paying down the credit card (if your APR is 24.99%, compounded daily). If an emergency did come up that required more than one month’s expenses, adding new charges to the credit card would just put you back where you were before you began aggressively paying down the balance. You would still be paying 28% annually on your credit card balance, but at least you would not have been paying this high rate of interest on the portion you aggressively paid down before needing to charge more to the credit card because of the emergency.
If you are savvy enough to have been contributing to a Roth IRA, in some ways you can treat this as an emergency fund because the principal can be withdrawn at any time without penalty. However, this should be avoided, because you are emptying out a “bucket” from a prior year that cannot be refilled. Each year you are limited to contributing a certain amount (currently $5,500 or $6,500 for those 50 and older), so withdrawing part of your principal will cost you a lot of tax-free capital gains in the long term.
On the other hand, contributing to a Roth IRA instead of an emergency fund is wise. Because you would not have been contributing otherwise, you are filling up one of the annual buckets that would otherwise have been empty. Therefore, if you must withdraw the principal, you are withdrawing money that would otherwise have gone into a Roth IRA anyway, so the opportunity cost of placing your emergency fund in a Roth IRA is zero, if you would not otherwise have contributed the annual maximum to the Roth IRA. Note that while the principal can be withdrawn without penalty from a Roth IRA at any time, this does not apply to Roth 401(k) or Roth 403(b) accounts. It also does not apply to traditional IRAs, 401(k)s, or 403(b)s.
Although I and many other savvy financial people recommend investing your retirement and taxable brokerage accounts in low-cost index funds of the whole stock market (perhaps with a mix of three funds covering U.S. stocks, international stocks, and bonds), a problem with putting your emergency fund in the market is that job loss is often correlated with temporary market declines (“crashes”). For instance, many people lost their jobs in 2008–2009 during the stock market crash… It would have been a shame to have to dip into one’s stock portfolio then, because of the enormous temporary decline which was followed by an even more enormous decade-long rally. Roth IRAs, like other tax-advantaged retirement accounts, are just wrappers for other types of investments, and you can change the investment type without penalty. Therefore, you could put your Roth IRA in bonds or a money market fund during the time it is acting as your emergency fund, and then switch all or part of it to stocks when appropriate.
The possibility of market declines is why the emergency fund is better placed in something safe and liquid like a Discover savings account that pays 1.45% annual interest (anyone can sign up for an AAII Discover Savings account—presently the rate is slightly higher than the 1.40% annual percentage yield [APY] offered with the regular Discover savings account). You could also place your emergency fund in a savings account through your primary bank, but a problem here is that it would probably yield almost zero interest. Savings accounts from Bank of America, Chase, Wells Fargo, and other banks with retail branches typically offer something pathetic like a 0.03% APY. Online banks like Discover, Ally, Marcus, and others offer 1.00–1.50% APY with no fees or minimum balances. On an $18,000 emergency fund, a 1.50% APY is the difference between getting $270 per year and $5.40 per year at 0.03% APY. A downside is that online banks may require an automated clearing house (ACH) transfer to get the money into your regular checking account, which could take two business days. However, this can also be an upside, as it prevents you from being tempted to spend the emergency fund.
A simple way to start the emergency fund is to immediately set aside a portion of each paycheck. It can be difficult to just keep extra money in your checking account as, psychologically, you are more likely to spend it. However, opening a separate savings account, particularly at an outside bank offering a competitive interest rate, makes you much more likely to not spend your emergency fund. If you receive pay via direct deposit (ACH transfer), you can direct your employer to deposit the first $100.00 (or some other amount) from each paycheck to the savings account, which prevents you from even seeing it in your checking balance. This is a great way to get started on your emergency fund—your first step toward financial independence.
The piggy bank photo is by Ken Teegardin from Flickr, available under CC BY-SA 2.0 license.
