Emergency Reserve Fund

If you embrace my money management strategies, there’s not a lot of wiggle room in your budget. Savings are taken off the top of every paycheck, and sometimes through no fault of your own, you simply can’t afford to live on what’s left over. That’s what an emergency reserve fund is for.

What’s an Emergency?

True emergencies are, well, they’re emergencies! You or your spouse lose their job. You must pay a big, unexpected medical bill. Your house is flooded and there is a large deductible to pay.

What’s Not an Emergency?

This is when having an effective budget comes in handy. Your budget should allow for vacation, minor car repairs, getting a leaky sink fixed, and expenses for extra-curricular school activities. In a perfect world, those expenses and more are anticipated and budgeted, and you never have to tap your emergency reserve fund. You do the best you can.

How Much?

How much should you put in your emergency reserve fund? “Save three to six months of living expenses in your emergency reserve fund.” That’s the old standby we financial planners like to throw around. After living through the pandemic and a recession on the horizon, I’m thinking that’s not enough for some people.

Whatever amount makes you sleep a little bit easier at night, that’s the amount you should put in your emergency reserve fund. If you’re confident your current income stream will continue and your financial house is in tip-top shape, leave the amount where it is.

Up it a few months of expenses or up to a year and a half if that makes you feel better. Don’t fund it with too much, though. This money must be kept safe and available, which means your rate of return is going to be minimal.

Where to Stash It?

The nature of an emergency is such that you never know when it’s going to happen. That’s why you need to keep your emergency reserve fund liquid and safe.

Being liquid means money is available quickly when you need it most. As an example, it can’t be tied up in a certificate of deposit, where there is a penalty if liquidated before the maturation date.

The money also needs to be safe. If you need 6 months of living expenses, the money had better be there. For example, if you invested your emergency reserve fund in stock, and the stock market is currently going south and now it’s down to just 4 months of living expenses, that could be a problem.

Don’t Settle

There’s something to be said for convenience. You could open a savings account or a money market fund—both good candidates for your emergency reserve fund—at your local bank. But what rate would you be earning? Many big banks pay abysmal rates, many times less than others. It’s not much, you say, and the tellers are so friendly.

It may appear small, but when you start adding up a higher rate here and fewer expenses there in all areas of your saving, spending, and investing, it makes a huge difference, especially over time. So don’t settle.

Seek out higher rates of return, including where you stash your emergency reserve fund. As mentioned, high-interest savings accounts and money markets are candidates. The good ones not only pay a higher interest rate than most but also carry FDIC insurance. Not only is your cash invested in a super-safe investment that is subject to little risk, but it’s also insured by the federal government for $250,000 per account, $500,000 if it’s a joint account.

Where do you find these higher rates of return? I’ll let you do your own research. Or check out a past Best Money Newsletter How Safe is Your Money? for options. In this era of big data, assuming you can navigate through the advertisements (which you want to avoid), it’s easy to find the higher-performing ones that carry FDIC insurance.

You’ll notice many of those offering higher yields are online banks, which probably don’t have a brick-and-mortar location near you. This is where you may have to give up some convenience for utility. Still, establishing an online account with an electronic transfer link to your local bank account gives you access to your money in just a few days. Many accounts offer even faster and more convenient access via debit card or check-writing capability.

If you’re a more aggressive investor, you still need to follow the rules as far as choosing a safe and liquid investment. If you want to shoot for a slightly higher rate with just a little bit more risk, consider an ultra-short bond ETF, like the one offered through Vanguard® (https://investor.vanguard.com/etf/profile/VUSB/). As of Wednesday (May 3, 2023), VUSB had a 30-day SEC yield of 4.96%, which is higher than what insured savings accounts and money markets are currently paying.

Incorporate Your Roth IRA

First, let me explain why I believe everyone should have a Roth IRA, even if you have a Roth option at work. Your prior principal contributions are accessible at any time with no tax or penalty. You don’t have to be 59 1/2, or for that matter even have a good reason for making a withdrawal. It’s one of the few retirement accounts that have that option. I’ve found a lot of people don’t know that.

I’m not talking about your Roth IRA earnings (interest, dividends, and capital gains). Those monies must stay in your account until age 59 1/2 to withdraw tax and penalty-free. I’m talking about your principal contributions only.

So, if you’ve got at least five figures worth of contributions in your Roth IRA, consider using a portion of it as your “backup” emergency reserve fund.

Slash your current emergency reserve fund by a quarter or a half. Immediately apply that extra money to your most important financial goal, whether that be debt elimination, retirement, or purchasing real estate. Enjoy your goal’s acceleration and hope you won’t have to tap that Roth IRA until you really want to. It’s been my experience that most emergencies are for less than half of a fully funded emergency fund.

Only use this strategy if you have a conservative element in your Roth IRA investment plan. For example, I don’t want my daughter, who’s in her early thirties, to use this strategy. Even though she’s made plenty of Roth IRA contributions she can access tax and penalty-free, her stock-to-bond ratio is set at 99-1 (99% risky investments). If a down stock market and expensive emergency struck her at the same time, she could be faced with liquidating stock at bargain basement prices, something no investor ever wants to do.

By the way, a nearly all-risky portfolio in my daughter’s case is not considered overly aggressive given she has an investing time horizon of 25-plus years. As she ages and her time horizon decreases, she’ll start to add more and more conservative investments to the mix. Only then would this emergency fund strategy make sense.

If you’re unlucky and misfortune strikes, be sure and try to replenish your Roth IRA once things calm down. If you’ve already exceeded the maximum Roth IRA contribution limit for the year or are over the Roth IRA Income limits, make sure you rebalance and reassess to properly account for the withdrawal.

Emergency Reserve versus Debt Elimination

What if you’re struggling to pay off high-interest debt and don’t yet have a fully funded emergency reserve fund? Which do you prioritize? They’re obviously both important. If you’re more on the conservative side, I’d suggest funding the emergency reserve first.

On the other hand, you want to start pounding away at that high-interest debt as quickly and with as much money as possible too. I suppose attacking them both at the same time is another option. Pick the strategy that feels right.

If you’re in this situation, I implore you to download my free e-book Best Debt Elimination Plan. This link is permanently free. There are no strings attached. You won’t even need to leave an email, and you can download it in any format you like, even a .pdf.

I want everyone to have this potentially life-changing information. Trust me, the Best Debt Elimination Plan contains information the credit card companies, big banks, and auto dealers don’t want you to know.

A paperback version is also available at a low cost, as is an Audible version (narrated by me, Keith Dorney).