Emergency Fund Placement: Where In Your Portfolio?

An emergency fund is a crucial part of financial planning, but where you keep it is just as important as having one in the first place. The ideal place for your emergency fund is somewhere safe and easily accessible, such as a savings account, with a competitive interest rate to help your money grow.

1. High-yield savings account: These accounts, usually found at online banks, offer higher interest rates than traditional savings accounts, allowing your emergency fund to grow faster. However, transferring funds may take a day or two, so it's a good idea to keep a portion of your money in an account with immediate access.

2. Money market account: Money market accounts are similar to high-yield savings accounts but often come with added benefits like a debit card and check-writing capabilities. They usually require a larger minimum deposit and can be opened at local or online banks, with the latter typically offering higher interest rates.

3. Certificate of Deposit (CD): CDs offer a guaranteed rate of return in exchange for keeping your money in the account for a specific period. However, withdrawing funds before the maturity date typically incurs an early withdrawal penalty. To avoid this, you can create a CD ladder by rolling over multiple CDs of varying term lengths, ensuring some of your emergency funds remain accessible.

4. Traditional bank account: If you prefer the peace of mind of having immediate access to your emergency funds, a traditional checking or savings account at a brick-and-mortar bank might be a better option. However, you may sacrifice earning potential, as these accounts often offer lower interest rates or none at all.

5. Roth Individual Retirement Account (IRA): Investing your emergency fund in a Roth IRA could provide higher returns in the long run, but it also carries the risk of losing value. You can withdraw your contributions at any time without penalty, but there may be tax implications and early withdrawal penalties for withdrawing earnings.

High-yield savings accounts

A high-yield savings account is a great option for your emergency fund. These accounts generally provide higher interest rates than traditional savings accounts, allowing your emergency fund to grow faster. For example, according to the FDIC, you can earn 3% to 4% from many high-yield savings accounts compared to an average APY of about 0.3% from traditional savings accounts.

When choosing a high-yield savings account, consider the following:

• Interest rates: Look for accounts with competitive APYs to maximize your earnings.
• Fees: Choose an account with low or no monthly maintenance fees.
• Minimum balance requirements: Ensure you can meet any minimum balance requirements to earn interest.
• Accessibility: Opt for an account that offers easy access to your funds, such as through online transfers or ATM withdrawals.
• Customer service: Select a bank with responsive and helpful customer support.
• Reputation: Go with a reputable bank with a strong track record of offering attractive interest rates.

Money market accounts

You can open a money market account at most local banks and online banks, with the latter often offering higher interest rates. However, be aware that there may be a larger minimum deposit required to open an account.

Compared to a traditional savings account, a money market account provides a higher APY and more convenient access to your funds. However, you may need to transfer funds from this account to another in order to withdraw cash or make payments.

Certificates of deposit (CDs)

When considering a CD for your emergency fund, it is important to keep in mind that you usually have to pay a penalty for cashing out the CD before it matures. This can make it more difficult to access your money if you need it immediately. One way to mitigate this is to create a CD ladder, where you buy several smaller CDs that mature at different intervals instead of one large CD. This can help increase liquidity and avoid or minimize early withdrawal penalties.

Another option to consider is a no-penalty CD, which lets you withdraw your money without sacrificing any of the interest you have earned. No-penalty CDs typically earn a lower interest rate than regular CDs, but they offer more liquidity.

Overall, CDs can be a good option for your emergency fund if you are comfortable with the early withdrawal penalties and/or are able to create a CD ladder. They offer a higher interest rate than traditional savings accounts and are considered a safe place to keep your money.

Traditional bank accounts

One risk to consider with traditional bank accounts is the potential for withdrawing money when it's not a true emergency. To combat this, you could open an account at a different bank from your other checking and savings accounts, adding a degree of difficulty that may help prevent unnecessary withdrawals.

Another benefit of traditional bank accounts is that they often offer similar deposit accounts to banks and credit unions, although credit unions typically serve only those in a specific community or geographic area. Banks, on the other hand, usually offer their products and services to everyone.

While traditional bank accounts provide easy access to your emergency funds, they may sacrifice earning potential. Institutions with large networks of physical branches may offer lower yields compared to low-overhead, online-only banks.

Overall, traditional bank accounts can be a suitable option for storing your emergency fund, offering the convenience of quick access to your funds and the peace of mind that comes with it.

Roth Individual Retirement Accounts (IRAs)

A Roth IRA is a type of tax-advantaged individual retirement account (IRA) that allows you to contribute after-tax dollars toward your retirement. The primary benefit of a Roth IRA is that your contributions and the earnings on those contributions can grow tax-free and be withdrawn tax-free after age 59½, assuming the account has been open for at least five years. In other words, you pay taxes on money going into your Roth IRA, and then all future withdrawals of earnings are free from tax and penalty.

Roth IRAs are similar to traditional IRAs, with the biggest distinction being how the two are taxed. Roth IRAs are funded with after-tax dollars. Unlike a traditional IRA, the contributions are not tax-deductible, but once you start withdrawing funds, the money you take out is tax-free.

A Roth IRA is best if you expect your marginal tax rate to be higher in retirement than it is right now. Single filers could not contribute to a Roth IRA in 2023 if their modified adjusted gross income (MAGI) was more than $153,000. For married couples filing jointly, the limit was $228,000. In 2024, the contribution limits increase to $161,000 and $240,000, respectively.

The amount that you can contribute changes periodically. In 2023, the limit increased to $6,500 (plus an additional $1,000 for those 50 and older). In 2024, the limit increases again to $7,000 with the catch-up contribution cap remaining at $1,000.

Almost all brokerage firms, both brick-and-mortar and online, offer a Roth IRA. So do most banks and investment companies.

A Roth IRA can be funded from a number of sources:

• Regular contributions
• Spousal IRA contributions
• Rollover contributions

All Roth IRA contributions must be made in cash (which includes checks and money orders) unless they are rollover contributions. They can’t be in the form of securities or property. The Internal Revenue Service (IRS) limits how much can be deposited annually in any type of IRA, adjusting the amounts periodically. The contribution limits are the same for traditional and Roth IRAs.

Similar to other qualified retirement plan accounts, the money invested in a Roth IRA grows tax-free. However, a Roth IRA is less restrictive than other accounts. The account holder can maintain the Roth IRA indefinitely. There are no required minimum distributions (RMDs) during their lifetime, as there are with 401(k)s and traditional IRAs.

Additionally, if you are covered by an employer's retirement plan, such as a 401(k) or 403(b), you can still contribute the maximum annual amount to a Roth IRA as long as you don't exceed the IRS's income limits.

There are, however, some drawbacks to a Roth IRA. Firstly, if your income is above a certain amount, which the IRS adjusts periodically, you become ineligible to contribute. Secondly, you cannot deduct contributions to a Roth IRA. Thirdly, if you withdraw earnings before you meet the time requirements, your earnings may be subject to taxes and/or a 10% early distribution penalty.

Frequently asked questions