How to Make Your Emergency Fund Work Harder for You

October 24, 2013

Emergency funds are the Rodney Dangerfield of financial planning: they get no respect. While financial experts typically recommend keeping at least 3-6 and sometimes even as much as 9-12 months’ worth of necessary expenses in cash reserves for  emergencies, no one really likes seeing all that money sitting somewhere earning less than 1%. Here are some ways to make that emergency money work harder for you:

Rewards Checking Account

Having at least part of your emergency money in your checking account ensures that you’ll have the money safe and quickly available when you need it. The problem is that most checking accounts are paying practically nothing. On sites like Deposit Accounts, you can find several checking accounts paying as much as 3% in interest. What’s the catch? They’re all small community banks and credit unions that may not be local to you so you’d have to do your banking remotely. To get the high rate, you also have to satisfy requirements each month like using direct deposit, electronic statements, and the bank’s debit card at least 10-15 times a month.

Roth IRA

For a longer term benefit, consider using a Roth IRA as your emergency fund. That’s because unlike other retirement accounts, you can withdraw the sum of your contributions at anytime and for any reason without tax or penalty. You just have to complete a withdrawal form that can also help to discourage you from raiding the account for frivolous purposes. The advantage is that anything you don’t withdraw can grow to be tax-free after age 59 ½ (and having the account for at least 5 years) so you’re saving for emergencies and your retirement at the same time.

Conservative Investment Portfolio

If you can over-fund your emergency fund by about 30%, there’s actually a case for investing the money in a portfolio with about 30-50% in stocks. That may sound risky but historically you would rarely fall below 100% funding of your target emergency fund during a market decline. The upside is that your emergency fund can grow much faster in the long run while a traditional savings account is likely to fall behind inflation. (This strategy works even better in the Roth IRA as discussed above.)

The best approach might be a combination of all three. Start by saving some extra cash in a rewards checking account. Then contribute to a Roth IRA and keep the money in a savings account or money market fund until your emergency fund is 130% funded. At that point, you can switch over to a conservative balanced fund with 30-50% in stocks. An emergency fund isn’t exactly the most exciting aspect of financial planning but using these strategies can give your emergency fund an extra kick.