It’s Time to Build a Better Emergency Fund

Here’s how to do it.

Building emergency fund
••• JJPan/Getty Images  

When most people set out to build an emergency fund, they seem almost resigned to the fact that they’re going to earn almost no interest on the money. Most experts will recommend parking your emergency savings in the safety of a savings account, and even a “high-yield” savings account is unlikely to pay much more than 1 percent APY in today’s low-rate environment. That probably won’t even be enough to keep pace with inflation.

But do you really need to keep your entire emergency fund in a savings account? While a savings account should be part of your emergency financial strategy, it’s not the only way to make it work. Here’s how to build a better emergency fund.

1. Start With the Savings Account

Savings accounts are generally used for emergencies because the money is liquid and accessible, allowing you to quickly move the money into checking or even withdraw it as cash from an ATM. It’s also arguably the safest place for your money: Savings accounts are insured by the FDIC, and there’s no risk that you’ll lose money if the market takes a dive.

But that doesn’t mean you should keep all of your money there. While a good emergency fund should cover to three-to-six months’ worth of living expenses, the savings account portion of my own emergency fund only has savings comprising three-to-four weeks’ worth of expenses. This cover my short-term needs, and if I need money quickly, I can access enough money to last me until I can liquidate money from other accounts.

2. Add a Taxable Investment Account

Of course, three to four weeks’ worth of expenses isn’t enough for an emergency fund. That’s why I augment my savings with the help of an investment account, which allows me to see a higher potential for returns than a savings account. I use a taxable account, rather than a retirement account like an IRA, so that I can withdraw money without incurring a penalty. I invest a set amount in an all-market index fund, and as the market gains, my emergency fund grows. I consistently invest, so the account is always growing anyway.

Of course, the big risk with this approach is that the market could be on the downswing when you need money. While the market always goes up in the long-run, in the short term you could end up with savings below a level you are comfortable with. And if you end up withdrawing some of your capital along with earnings, you’ll lock in losses and miss out on the gains that tend to follow a market correction.

This happened to me in 2010—shortly after the market took a nosedive, my basement flooded and I needed money. Because I was billed later I had time to liquidate some shares in my taxable investment account to cover the costs. And the balance of my account hadn’t fallen so far that I was in trouble of running out of money. But it did mean that I was selling shares at a loss and missing out on some of the market’s subsequent rebound.

Because of this risk, you need good emotional risk tolerance if you plan to add an investment account to your emergency fund strategy. On top of that, you can limit some of your risk by using bonds and index funds in the taxable investment account portion of your emergency fund, thereby decreasing your exposure to market volatility.

Finally, keep in mind the tax implications of selling investments in a taxable account. In 2010 I had to sell investments at a loss, but the good news was that I could at least realize a tax deduction for that loss. On the other hand, if you sell for gains, you’ll likely have to pay capital gains taxes. Focus on selling shares you’ve had for more than a year first, so you are taxed at a more favorable rate.

3. Use Your Roth IRA as a Backup Fund

If you are eligible, and you invest in a Roth IRA, it’s possible to use it as a backup emergency fund. Because you contribute to the Roth IRA with after-tax dollars, you can withdraw contributions without penalty. When you contribute regularly, you can build your Roth IRA to the point where it can make a good stop-gap if needed.

However, while you can withdraw contributions tax-free, you have to be more careful when withdrawing earnings (the returns on your contributions) from a Roth IRA. Early withdrawals of earnings come with a penalty from the IRS, so make sure you stick to money you actually put into the account. There are some exceptions to this penalty, though: You can withdraw earnings to pay for medical expenses or if you’re unemployed. Since these are common emergency needs, it might not be a bad idea to have your Roth IRA waiting in the wings.

Also, realize that you can’t get back the time the money spends out of the market. You have 60 days to put the money back if you want to make sure it stays within the annual contribution limit. It’s a good idea to have another tax-advantaged retirement account like your 401(k), and avoid touching that at all. You don’t want to risk your future for today’s emergency.

Tweak Your Emergency Savings Plan as Needed

When using this strategy, it’s important to make sure you work to your comfort level. I like to keep three or four weeks’ worth of expenses in my savings account, and my taxable investment account has close to five months’ worth of expenses (and it’s still growing). My Roth IRA is in the background for the “just in case” big stuff.

If having more than 80 percent of your emergency fund in the market makes you nervous, you might feel better keeping two or three months’ worth of expenses in a savings account before putting money in a taxable investment account. Additionally, you also want to ensure that your retirement savings plan works well with your emergency fund strategy. You don’t want to lean heavily on your Roth IRA unless you have another retirement account for your long-term nest egg.