Emergency Funds

Over a century ago, stage magician Nevil Maskelyne wrote in The Magic Circular (1):

"It is an experience common to all men to find that, on any special occasion, such as the production of a magical effect for the first time in public, everything that can go wrong will go wrong. Whether we must attribute this to the malignity of matter or to the total depravity of inanimate things, whether the exciting cause is hurry, worry, or what not, the fact remains."

Whether or not you subscribe to the Resistentialist theories that inanimate objects are out to get us (2), Murphy's Law - and its endless corollaries (3) - pretty much sums it up: if it can go wrong, you'd best bet it will.

This is the rationale behind holding some of your assets in an emergency fund.  Ideally, you'll never touch it - all of your job transitions will be carefully planned, your injuries will all be taken care of with Band-Aids and medical tape, natural disasters will hold off while you're in town, and you'll die in perfect health while mountain biking at the age of 112.

The cargo ship Ital Florida runs into some... issues in June 2007 (X1)
The best bet: hope for the best and plan for the worst, in proportion to an event's severity and its probability of occurring.

How much should I save in an emergency fund?

It's obvious that you should always have enough cash in your bank account to cover the month's expected expenses, plus a little extra to account for month-to-month variations, to get you to the next paycheck.  Equally obvious, you don't want years' worth of expenses held in savings and checking - you're giving up the capital gains you could be making by investing in the markets or your own business.  If the inflation rate is higher than your account interest rate, you're losing money!

Financial experts recommend saving anywhere from 2-12 months of expenses in an emergency fund.  When deciding how much to save, make sure you take into account:
  • Job stability - does your industry have high turnover? do you have seniority?
  • Employability - if you lost your job today, how long might it take you to find a new one?
  • Health history - can you anticipate any 'unexpected' healthcare costs?
  • Emergency maneuvers! - how far are you willing and able to scale back your expenses if disaster strikes?
  • Life rafts? - have you established agreements that you could seek help from family or friends?

Cash, Savings Accounts, CDs... Where should I save it?

All of those wonderful tax-advantaged investment accounts I've talked about previously - Traditional IRA, 401(k), 403(b), 457(b), 529 Plan - have restrictions on when you can withdraw your money.  If you're faced with an unanticipated financial hardship like a natural disaster or a massive hospital bills, most account types will ease up these restrictions somewhat.  But it's a poor strategy to rely on this - these plans offer no help in the face of the most common small-scale disasters (totaled your car, fired from your job, &etc).  And anyway, money in these accounts has been set aside for the future!  You need some backup funds stored in a readily available location.

The Roth IRA is a bit different, because it allows you to withdraw the principal (the amount you contributed) at any time and for any reason with no taxes or fees.  If you can't afford to fully-fund an emergency fund and max out your Roth IRA contributions ($5500/year in 2013), see 'Emergency Fund vs. Retirement Savings' below.

Taxable Brokerage Account
You can sell securities held in a regular old taxable brokerage account at any time and for any reason.  This could be your emergency fund, but it still might take a few days to sell your holdings and have the money you need in your bank account.  There's also a Chinese proverb (5) to be considered: "blessings never come in pairs, and misfortunes never come singly."  Unemployment is quite likely to coincide with a significant drop in the markets, so you could be forced to sell exactly when you'd really prefer not.  If you have a large, diversified positive cashflow, excellent health, a strong personal network safety net and no concerns about job loss, it could be reasonable to use the more conservative portions of your brokerage account as your emergency funds.  Just make sure you that the amount set aside takes into account potential losses - if the stock market drops 50%, your 6 months of saved expenses are now 3 months of saved expenses.

Cash, Credit and Savings Accounts
How about... cash under the bed?  This option is great if you need the money today, but not so great if your house burns down or is burglarized.  Most people therefore do the next best thing and keep their emergency funds in cash in a bank savings account.  This is a fine option, but make sure you're monitoring the account interest rate (6) and the current inflation rate (7), usually represented by the US Bureau of Labor Statistics' CPI-U (8) - if the inflation rate is higher than your account interest rate, you're losing money!

Certificates of Deposit (CDs)
Most banks also offer an investment product called a CD.  In exchange for agreeing to keep your money in the CD for a longer period of time (usually 1-10 years), the bank will pay you a higher interest rate.  If you withdraw your money before the stated term is up, you'll pay a penalty, usually in the form of the last few months' interest.  CDs are a great option because the money is readily available, but if you never need it you will at least collect a little interest on it.

Way back in the late 90's when interest rates were sky-high, you could get a multi-year CD at 6% interest.  Nowadays?  Hahahahah.  Five-year CDs are going for about 1.5%.

US Treasury I-Bonds Protect Against Inflation

Oftentimes, financial experts (and bloggers, and Redditors) will point out that an emergency fund is a form of insurance, and that insurance costs money.  This may be so, but that doesn't mean you shouldn't shop around to find the best price!  I-Bonds are potentially a very low-cost, no-risk solution to the emergency fund problem.
A $1000 paper I-Bond.  SMART.
I invest in US Treasury Series-I Savings Bonds (I-Bonds) for my own emergency fund needs.  Their interest rate, which is adjusted every six months, is the current inflation rate plus a fixed rate that is set when the bond is purchased (9,10).  If the inflation rate is negative, the inflation rate contribution will subtract from the fixed rate contribution, but the overall composite rate is never allowed to drop below 0% - in other words, you can't lose money invested in I-Bonds.  As the historical rate charts show (original data and charts here), I-Bond interest rates have been low recently:
The fixed rate set for I-Bonds has declined steadily since 1998; interest rates have fluctuated at around 2%
The I-Bond interest rates possible over the years; the rate you get in the above ranges depends on the fixed rate set at purchase.
The current I-Bond fixed rate is 0%, so the value of an I-Bond purchased today will keep up with inflation but won't earn any extra interest.   You can expect the fixed rate on newly-issued I-Bonds to increase when interest rates, currently at record lows, begin to rise again; this will likely happen when the US Federal Reserve halts Quantitative Easing (11), a program designed to suppress interest rates.  But, it's anyone's guess when that will occur (12)!

I-Bonds may not be redeemed until one year after purchase, and redeeming before five years after purchase triggers a modest penalty of the previous three months’ interest. These bonds continue earning interest as described until they ‘mature’ at 30 years after purchase, at which point they must be cashed.

I-Bonds also offer tax advantages
US Savings Bonds are only taxed at the federal level, so you never owe state or local taxes on their interest earnings.  You have a choice of either:
  1. paying tax on the interest on your bonds’ earnings each year, or
  2. deferring tax on the interest until the bonds mature (30 years) or are cashed in.
You must use the same method for all of your bonds. The default mode is deferred reporting, but you can switch to annual reporting at any time without filling out any paperwork - on the tax year you switch methods, just report all of the interest income you had been deferring. If you make the switch to annual reporting and want to switch back to deferred reporting (make up your mind already!), you’ll need to fill out IRS Form 3115 - Application for Change in Accounting Method. The IRS explains this on their website (13).

In general, it’s most advantageous to defer the taxes until the end - the time-value linkage of money means that it’s always better to pay a given value later rather than sooner, and paying later gives inflation more time to grind down the real value of the dollar amount you’ll owe.  It would only be advantageous to pay yearly if you expect to jump to a significantly higher tax bracket in the year you cash out your bonds.  (This calculation is left as an exercise for the reader.)

If you pay higher education expenses, US Savings Bond interest in that year up to the value of the higher education expenses is tax-exempt.  To claim this exclusion, you must fill out IRS Form 8815 - Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989.

Watch the withdrawal limitation!
If you wish to convert a portion of your emergency fund into I-Bonds, keep in mind that the money will be unavailable for 1 year.  Make sure to keep plenty of emergency funds in cash, savings, or a CD that you can access, while you wait for money in your newly-purchased I-Bonds to become available for withdrawal if an emergency should arise.

Electronic I-Bonds are purchased online, but there's still one way to get paper bonds
US Treasury Savings Bonds may only be purchased on TreasuryDirect. US Treasury Bonds are not ‘marketable securities’, so you can’t buy and sell them with others on an open market like you can with corporate stocks and bonds. If you buy a US Treasury Bond from another person, you may own the piece of paper but the US Treasury still owes the payment to the original purchaser, whose name is on the bond itself.

Each person with a Social Security Number may purchase $10,000 in electronic savings Bonds. Electronic bonds are sold in $25 increments, though you may purchase them in any amount to the penny over $25.

The Treasury is phasing out paper bonds to cut costs, but there is still one way to get them: through your federal tax return. You may purchase an additional $5,000 per year in paper I-Bonds by filing IRS Form 8888 - Allocation of Refund (Including Savings Bond Purchases). Details are available on the IRS website (14).

If you would like to purchase more paper I-Bonds than your refund is likely to finance, you can purposefully overpay your taxes and increase your refund.  This is perfectly legal.

One option is to overpay using an estimated quarterly tax payment by January 15th using IRS Form 1040-ES.  The issue: or the time between your quarterly payment and the date the refund is issued, you lose out on the ability to make any interest on that money and will have essentially made a three-month interest-free loan to the government.

INSTEAD, use this method: request a tax filing extension using IRS Form 4868.  Purposefully overpay on Line 7, submit the form and wait for it to clear, then file your 1040 as you usually would, along with Form 8888 to get your paper bonds.

Two additional facts to consider when purchasing:
  1. Bonds are always treated as if you bought them on the first day of the purchasing month
    (hint: buy late in the month!)
  2. Interest rates are announced in advance of a change
    (hint: check to see if and how the rates are changing!)
Electronic I-Bonds are redeemed online; paper I-Bonds are redeemed at any bank
Electronic US Treasury Bonds are redeemed online through TreasuryDirect.  Electronic redemption is extremely rapid, and the money may be in your bank account in as few as two days. Paper bonds may be redeemed in person at most financial institutions.

For more information on I-Bonds, see Wikipedia (15), Investopedia (16), and the Bogleheads Wiki (17).

Emergency Fund vs. Retirement Savings

Saving for the future is absolutely crucial, but you must prioritize.  Just like you would never contribute to a retirement account while owing high-interest credit card debt because it makes absolutely no mathematical sense, saving for retirement is necessarily a lower priority than stockpiling money to deal with emergencies.

(To be clear, you should absolutely be doing both of these things.  If you "can't afford" to do this, either you're an undergrad or starving grad student - and by this I mean you're in grad school in a discipline that pays little or nothing, so all of my fellow engineering and applied science grad students making $25-35k are NOT exempt - or something is seriously out of whack with your lifestyle.  Get educated, get your priorities straight, and repent your financial sins.)

That being said...

Situation #1) You CANNOT afford a contribution to an emergency fund IN ADDITION to maxing out your yearly Roth IRA contributions ($458/month).

In this case, it is advantageous to store your emergency funds in your Roth IRA. Invest these emergency fund contributions much more conservatively than you would your retirement savings, for instance in bond index mutual funds (Vanguard's VBMFX, Fidelity's FBIDX), money markets, CDs, and other capital preservation and cash-like assets. You may withdraw all of the money you have contributed to your Roth IRA at any time and for any reason, without taxes or fees. Your contributions will accumulate tax-free earnings for retirement, though you CANNOT withdraw these earnings in an emergency without paying taxes and fees.  In the best-case scenario you will never touch this money, eventually moving into more aggressive investments as you fund an emergency fund elsewhere.

Situation #2) You CAN afford a contribution to an emergency fund IN ADDITION to maxing out your yearly Roth IRA contributions ($458/month).

In this case, it is advantageous to max out your Roth IRA retirement savings and store your emergency funds in a savings account, CD, or I-Bonds.  If you are a student eligible to use a 529 plan, you should consider storing a portion of your emergency funds there instead. You don't pay capital gains taxes, your yearly contributions are practically unlimited, and your tax- and fee-free withdrawals are limited only by your total annual educational expenses INCLUDING food, utilities, and rent. Unlike a Roth IRA, you are permitted to withdraw all of your contributions AND earnings up to your total annual education expenses.  Every graduate student should consider a 529 Plan.

Interest Rates of Various Emergency Fund Options (2013.05.17)

Savings Accounts and CDs - Ally Bank
Ally offers savings accounts and CDs with high rates, no annual fees, and no minimum deposits:

Ally Bank CDs - High Yield and Raise-Your-Rate
1 year - 0.94% - early withdrawal penalty of 60 days’ interest
2 years - 1.05% - early withdrawal penalty of 60 days’ interest, you may raise rate once to a new higher rate
3 years - 1.19% - early withdrawal penalty of 60 days’ interest
4 years - 1.30% - early withdrawal penalty of 60 days’ interest, you may raise rate twice to a new higher rate
5 years - 1.51% - early withdrawal penalty of 60 days’ interest

US Treasury Series-I Savings Bonds
The interest rate you make is the fixed rate set at the time you purchased the bonds, plus the current inflation rate as calculated by the Consumer Price Index for Urban Consumers (CPI-U)

Current fixed rate: 0.00%
Current inflation rate: 1.18%


These options represent a range of interest rates and liquidity - the cash in your wallet is ready to go in an instant but is continuously suffering the ravages of inflation, while I-Bonds are inflation-proof but might take two or three days until you have the cash in-hand (unless you have paper bonds, which can be cashed at most banks).

So what's the emergency funder to do?  Take a simple tiered approach: keep a bit of cash immediately on-hand, buffer a bit beyond your estimated monthly expenses with money in a checking or savings account, and stockpile a few months' worth of expenses in I-Bonds.  This way, you'll have money available in a timely fashion while keeping inflation at bay as much as possible.

So... pay off that credit card debt, stock your emergency fund, and open that Roth IRA!  Future You will be pleased.

(1) Wikipedia: Murphy's Law - http://en.wikipedia.org/wiki/Murphy's_law
(2) Wikipedia: Resistantialism - http://en.wikipedia.org/wiki/Resistentialism
(3) Murphy's Law corollaries and variants - http://www.murphys-laws.com/murphy/murphy-laws.html
(6) Bankrate: Savings account interest rates - 
(7) US inflation data - 
(8) Bureau of Labor Statistics: CPI-U - http://www.bls.gov/cpi/
(10) I-Bonds and the CPI-U - http://www.ibonds.info/I-Bonds-and-CPI-U.aspx
(11) Wikipedia: Quantitative Easing - http://en.wikipedia.org/wiki/Quantitative_easing
(12) CNBC: The End of QE? - http://www.cnbc.com/id/100730473
(14) US Treasury: Buying I-Bonds with Tax Returns - http://www.treasurydirect.gov/indiv/research/faq/faq_irstaxfeature.htm
(16) Investopedia: Series-I Savings Bonds - http://www.investopedia.com/ask/answers/05/062105.asp
(17) Bogleheads Wiki: Series-I Savings Bonds - http://www.bogleheads.org/wiki/I_Savings_Bonds