Finding financial success takes a mix of caution and courage. You can’t grow your wealth by stashing it away somewhere safe, but you won’t have any wealth to grow if you’re constantly throwing caution to the wind. It’s a fine line, and most people skew to one direction or the other.
That’s why nobody can seem to agree on how to handle your emergency fund. Some see a savings account full of liquid cash as a wasted opportunity, while others see it as a source of stability. In some ways, this comes down to individual risk tolerance, but the answer for most people is pretty clear-cut.
So should you really leave your emergency fund alone, or should you invest it? Read below to find out.
Why You Probably Shouldn’t Invest Your Emergency Fund
If your emergency fund is in a savings account with 1% interest, it actually loses money every year due to inflation, which hovers around 3.22%. Some consumers invest their emergency fund to avoid that. The only way to beat inflation is to put your emergency fund in an account where it can earn more than 3.22%. Most investment options meet that criteria.
But while that sounds smart, it defeats the purpose of having an emergency fund in the first place. Consider what might happen if the market takes a downturn and you need money to pay for an emergency. If you had your money invested during the 2008 crash and immediately lost your job, not only would you be unemployed – you’d be surviving on a much smaller emergency fund.
Experts tend to agree that an emergency fund should be an element of stability, not another unknown quantity.
“If there is a chance that you can lose your job at the same time the investment markets take a downturn, that could be a recipe for financial disaster,” said Ryan Inman, financial planner and a host of the Financial Residency podcast.
Investing your emergency fund is counterintuitive. You should never withdraw money from an investment account when the market is down, but often that downturn could be causing the very emergency you need money to cover.
When you invest money in an emergency fund, you often have to pay an extra penalty or fee for withdrawing it. If you remove money from a traditional IRA or 401k before the age of 59, you’ll have to pay income tax as well as an extra 10% withdrawal fee. If you invest the money in a bond or CD with a maturity date, you’ll owe a fee for withdrawing before the account’s maturity date. The fee is usually three months’ worth of interest on a CD with a one-year or less maturity date, and six months’ worth of interest on a CD with a maturity date of 12 months or more. If you withdraw early enough, you could even lose money on the principal because the CD hasn’t had enough time to grow.
Kirsty Peev, CFP® and Portfolio Manager at Halpern Financial, puts the issue in simpler terms.
“The purpose of an emergency fund is security, not growth,” she said.
When It’s Ok to Invest Your Emergency Fund
There are rare instances where investing in an emergency fund can work out. People who are already retired, living on a government pension or who have the support of a spouse with a stable job can perhaps afford to be more aggressive.
David G. Metzger, CFA, CFP® of Onyx Wealth Management said he advises clients to put their emergency fund in a Roth IRA, where they can put the money in a CD, US Treasury fund or the custodian’s money market account.
Withdrawals from an IRA can be done tax-free and penalty-free before age 59.5 if you only take out your contributions, not your earnings. With Metzger’s method, consumers can pick a low-risk investment for their emergency fund to reap the benefits of higher returns.
“From a behavioral perspective, I find this approach helps to increase the likelihood that clients will only use the funds for true emergencies, since they know they are withdrawing from a retirement account and will have to file additional forms at tax time to report the distribution – even though it will be tax free,” he said.
If you’re the type of person who’s always tempted to withdraw money from a savings account, investing your emergency fund might actually be better.
A compromise between an index fund held in an IRA and a savings account is a CD ladder. A CD ladder is a strategy where you keep small amounts of your emergency fund in various CDs with different maturity dates. The idea is to stagger the CDs so they all mature at different times, allowing you to access them without paying a fee. This prevents you from having all of your money invested somewhere it can’t be touched without a penalty.
The downside here is that if you need access to your entire emergency fund, not all of it will be accessible without paying a fee. As with many things in the financial world, your risk tolerance should determine the best move here.
How to Store Your Emergency Fund
If you don’t want to invest your emergency fund, you still need to be conscious of where you put it. The ideal place is a savings account not connected to your everyday checking account, so you’re never tempted to dip into it for non-emergencies.
If you already have a savings account in place, check its interest rate. You might be surprised to find a huge variance in the interest rates offered by different banks. Online banks like Ally have some of the best interest rates around, and local credit unions often have 2% interest for savings accounts. That won’t match the 7% you might learn in an S&P 500 Index Fund, but your money will be FDIC-insured.
Make sure you have at least $1,000 saved up, but three to six months worth of expenses is really better. If you’re having trouble saving, try setting up automatic transfers from your bank account every month.