Emergency Savings: Invest Or Keep?

Emergency funds are a crucial financial safety net, providing peace of mind and protection against unexpected costs, such as medical bills, home repairs or travel expenses. While it's generally recommended to keep these funds in a savings account, some people consider investing their emergency savings to beat inflation and potentially grow their money faster. However, investing emergency funds is not without risks and drawbacks. This article will explore the pros and cons of investing your emergency savings and offer alternative options for those seeking higher returns.

Liquidity and accessibility

Liquidity:

• Emergency funds are meant to cover unexpected expenses, such as medical emergencies, home repairs, or job loss. It is recommended to have three to six months' worth of living expenses readily available.
• To maintain liquidity, consider investing in more liquid assets like money market accounts, high-yield savings accounts, or Certificates of Deposit (CDs). These options allow you to access your funds quickly without incurring penalties.
• Avoid investing emergency funds in volatile assets like stocks or real estate, as you may be forced to sell at a loss during an emergency.

Accessibility:

• Keep your emergency funds in a separate account from your daily expenses to avoid the temptation of dipping into them.
• Choose savings options that offer easy access to your money, such as accounts with debit card or check-writing privileges, or those that allow a certain number of free withdrawals.
• Online-only savings accounts may offer higher interest rates, but ensure you can access your funds quickly through electronic transfers or other means.
• In addition to accessibility, consider the safety of your emergency funds. Accounts insured by the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Association (NCUA) offer protection for your deposits.

Remember, the primary goal of your emergency savings is to provide a financial buffer during unexpected events. While investing can seem appealing, carefully consider the liquidity and accessibility of your funds to ensure they are readily available when you need them.

Risk of losing money

Investing your emergency fund can be risky because you could lose the money you put in. If you put your emergency fund into a savings account, you will still have the same amount of money a few months later. However, if you invest it, for example in stocks or index funds, it could be worth more, but it could also be worth less. This means you could have less money to cover an emergency expense.

For example, if you invest $5,000, it could be worth $6,000 in a few months if your investments increase in value. But it could also be worth $4,000, or even less, if your investments lose value. This means you could end up with less money to cover a surprise expense.

Investing your emergency fund can be especially risky if the market is volatile. If the market crashes, you could lose your job and have your emergency fund decrease in value at the same time. This could leave you in a difficult financial situation.

To avoid this risk, it is generally recommended to keep your emergency fund in a savings account or other low-risk, highly liquid account. This will preserve your initial deposit and ensure that you have the money you need when an emergency arises.

Tax consequences

Investing your emergency fund in a taxable brokerage account means you will be responsible for paying taxes when you sell shares and realise your gains. The tax rate you pay will depend on when you bought and sold the shares. If you sell assets you have held for one year or less, you will be subject to a short-term capital gains tax, which is usually the same as your regular income tax rate. On the other hand, if you sell assets you have kept for over a year, you will pay a long-term capital gains tax, which is between 0% and 20%.

It is generally better to be taxed at the long-term capital gains rate as you will typically owe less in taxes. However, as emergencies are unpredictable, you may have to sell your assets less than a year after buying them, meaning you will owe more in taxes.

If you invest your emergency fund in stocks, you may have to sell at a loss if you need the money quickly. Selling stocks can take several days, so you won't be able to access the cash instantly. It is recommended that you keep some of your emergency fund in a more liquid asset, like a money market account.

High-yield savings accounts

Money in a high-yield savings account, including online-only accounts, is typically FDIC-insured. The money earns interest, and you can access your cash quickly when needed, whether through withdrawal or a funds transfer.

• Barclays Tiered Savings Account
• SoFi Checking and Savings
• CIT Bank Platinum Savings
• American Express High Yield Savings Account
• Forbright Bank Growth Savings
• EverBank Performance Savings
• Capital One 360 Performance Savings
• UFB Portfolio Savings

Investment options

There are several options for investing your emergency fund. The most common advice is to put your emergency fund in a safe, low-risk, highly liquid account like a savings account or money market fund. This way, you can access it immediately when needed and not worry about it dropping in value.

However, with inflation, your money in a savings account or money market account will still lose value over time. Thus, some people have started to invest their emergency funds in a well-diversified portfolio that can be expected to grow over time instead of losing value due to inflation.

• Money market accounts: These are interest-bearing accounts at banks or credit unions that are a mix between a checking and savings account. They are considered low risk and can provide annual percentage yields (APYs) of about 3% to 4%. Most money market accounts are insured by the Federal Deposit Insurance Corporation (FDIC) or National Credit Union Association (NCUA), protecting your money up to $250,000 per account. Some banks offer money market accounts with debit card and/or check-writing privileges, giving you instant access to your funds.
• High-yield savings accounts: These accounts, often offered through online banks, can provide higher interest rates than traditional savings accounts, typically between 3% to 4% compared to an average of 0.3% for traditional savings accounts. Money in these accounts is usually FDIC-insured, and you can access your funds through online funds transfer, outgoing wire transfer, telephone transfer, or check request. However, with online-only accounts, you cannot access your funds at a branch location, and some methods of withdrawal can take several days.
• Certificates of Deposit (CDs): CDs can provide higher interest rates than keeping your money in a checking account. They offer FDIC protection for up to $250,000 per account. Longer-maturity CDs tend to have higher interest rates, but there is usually a penalty for cashing out before maturity, making it harder to access your money immediately. To increase liquidity and avoid early withdrawal penalties, you can create a CD ladder by buying several smaller CDs that mature at different intervals. Some banks also offer no-penalty CDs, which allow you to withdraw your money without sacrificing any earned interest, although the interest rate may be lower.
• Taxable brokerage account: You can invest your emergency fund in a taxable brokerage account, where it has the potential to grow. However, you will incur short- or long-term capital gains taxes depending on when you sell your investments.
• Roth IRA: You can also invest your emergency fund in a Roth IRA, where you can withdraw your contributions penalty-free and income tax-free. However, withdrawals before the age of 59½ or within five years of opening the account may be subject to taxes and/or penalties. Additionally, IRAs have annual contribution limits, which may be lower than the amount you need in your emergency fund.
• Diversified investment portfolio: If you are willing to take on some risk, you can invest your emergency fund in a well-diversified portfolio of stocks, bonds, and other assets. This allows your emergency fund to grow over time and potentially beat inflation. However, there is a risk of losing value if the market corrects, so it is important to assess your risk tolerance and consider overfunding your account to mitigate this risk.

It is important to note that investing your emergency fund may not be suitable for everyone. Those with a low tolerance for risk or who are just starting to build their emergency fund may be better off keeping their funds in a safe, low-risk account. Additionally, financial advisors recommend keeping at least three to six months' worth of expenses in highly liquid assets to cover unexpected costs.

Frequently asked questions