Use Roth IRA as your backup emergency fund

Pros

- Money grows tax free.  This works especially well if you don’t have a major emergency.

- Less temptation to take money out.  It would truly have to be an emergency if you have to withdraw your money and you would be less inclined to take money out for a questionable ‘emergency.’ (You know what these are.)

Cons

- Increased Hassle and paperwork.  It may take a few days to get your money when it’s in a Roth IRA. 

- You can only contribute $5,000 a year.  You can’t use your Roth like a checking account, moving money in and out of your account.  The idea is to put your money in and keep it there. 

Overall

I am not opposed to doing this as long your emergency is not aggressively invested.  I would also keep a portion of your emergency fund in a more accessible savings account where you can get you money in a couple of days.

ING checking or savings-  If you have been reading this blog at all, you know my heart, for savings accounts, lies at ingdirect.com.  

Money Market Funds-

You will see Money market funds in your brokerage accounts.  Money market funds are large pools of money invested in short term notes and historically return amounts that mirror the Fed interest rate.  With the Fed rate at 0-.25%, it is no wonder why money market funds are returning close to nothing.   If all else fails, you will know a money market fund by its price: constantly $1.00 per share every day.

Like I said before, you will not get rich from these funds (though you will not lose any money either.) 

Here is a list of some popular Money Market Funds:

Where Would I Not Put It?  CD’s. 

CD’s historically earn more interest than your traditional savings or money market.  However, I would currently advise against buying CD’s for a couple of reasons.

1. There are excessive fees if you need to access your money for an emergency when you are invested in a CD.
2. Interest rates are at historically low rates, which can’t go any lower.  Buying low and selling high is good for stocks, but buying a CD at a low rate locks in that low rate.  When interest rates rise, your CD rate remains the same.   It was only 2 years ago when an average money market savings account was making 5.00%.  With the economy gaining traction as well as our unprecedented government spending, I am expecting these rates to go back up (and then some) sooner before later. 

That being said, I don’t want to be locked in a 1.5% CD for more than 6 months at a time. 

Stocks

Your emergency fund and your investments are to perform different functions.   Stocks will be good for investments, and that step will come soon.  In the meantime, there are two main reasons not to invest your emergency fund in stocks.

1. Stocks fluctuate.  A lot.  I want to buy stocks low and sell them high.  When there is an emergency, there is no choice when to sell.  It’s now.  I want my emergency fund to remain constant, even if I feel that I am missing out on higher potential returns. 
2. Stocks take T+3 days to settle.  T means today and 3 means good business days.  MLK, Presidents Day, Memorial Day, and Labor Day are good business days for me (I work in the financial industry and have these days off)  but are not good business days for getting your money out of stocks.  Take for example, you sell your stock for an emergency on a Wednesday (T), that money is not available to withdraw until next Monday (+3) or Tuesday if there is a holiday.    Add another couple of days to get your hands on the money and you are at a full week.  Your emergency fund should be more accessible than that. 

Mutual Funds

Like stocks, there’s a time and place for mutual funds, but your emergency fund is not the place for them.   

Where do you invest your first $1000.00 and your emergency fund?

Savings Account

Just like your first $1000.00 saved, you want to find an account that:

1. Doesn’t charge you any fees to have the account.  Move your money out and close your account the first time you get charged and don’t look back. 
2. Gives you something in interest.  Don’t expect to earn a lot of interest these days, but if your money is making you zero, (I’ve been there) look for a new account.

I moved our emergency fund to www.ingdirect.com.  There are no account/balance fees and I currently earn 1.25 APY (as of Jan 15, 2010) 

Brokerage Account

Brokerage accounts can be a good place to house your emergency fund if you are dealing with the right company.   It is also convenient to keep all of your accounts (retirement and non-retirement) with the same company.  The same two rules apply for brokerage accounts.  In addition to the two rules, it is important that your brokerage company won’t charge you to get in and out of your money market, if you need to get the money. 

A couple of good places to start that won’t charge you fees:

Fidelity Investments – www.fidelity.com

Charles Schwab: www.schwab.com

Where are you/will you put your emergency savings?

Once the length, in months, is set, you can apply your monthly expenses to get your emergency savings goal. 

Emergency Savings Amount = Expenses per Month X Number of Months

Here are a few factors that need to be addressed to find the emergency fund target that’s right for you. 

Your Income.

Shannon italia, head of Career Services at the University of North Florida, told me that the average length of a job search depends on the salary you are looking for.  She believes that you can expect an average of 1 month search for every $10,000 in yearly salary.  According to this equation, if you are looking for jobs in the $30-$40k range, you can expect an average job search of 3-4 months.   If you are in the $80-$120k range, it may be 8-12 months before you find the right fit.

That being said, you will want to tailor your emergency fund around the above equation.   Those making a higher yearly salary will want to lengthen their emergency savings accordingly. 

Your Empoyer/Industry

Your employer and industry may play a part in the length of your emergency fund.  These are not hard and fast rules, but generally, the smaller the company, the more susceptible to layoffs you may be.  Is your employer making good profits quarter after quarter, or are they struggling to keep the lights on?  These answers may not be completely evident, but most employees can see clues when their company is struggling financially.  These are clues to perhaps lengthen your emergency fund.

Is the industry you work in a boom and bust industry?  If I were a doctor or a nurse, I would be shaking my head no.  If I were a mortgage broker or a real estate agent, I would be shaking my head yes.  This question also plays a role in how long your emergency fund should be.

Not sure how to answer this question?  Ask yourself how deeply your industry has been affected by the recent economic downturn.  I can say that for me, the financial/banking industry has been significantly impacted by the recent recession; therefore, we need to plan our emergency fund accordingly. 

Your Risk Tolerance

Your tolerance of risk should affect your length of emergency savings.  I know people who lost a lot of sleep in 2008 due to the economic turmoil and some people who were oblivious to it.  Both sets of people had money invested in the then tanking stock market, but reacted completely differently.  If you fall on the low end of the risk spectrum, you will want to add length to your emergency fund.  

Your risk tolerance, or lack thereof, is nothing to feel bad about.  It is simply something that needs to be addressed.   For married couples, this is an especially important issue to be addressed.   For instance, I would be a 7 out of 10 on a risk tolerance scale (1 being the lowest, 10 being the highest.) Dana would also be a 7.  I try to account for the average of the two of us when making decisions based on risk tolerance. 

Please remember to account for your spouse.  For a long time, our decisions were based on my risk tolerance.  Why?  I was making the financial decisions alone and not including my spouse.   I didn’t have ill intentions, I was just flying solo with our financial decisions.  Talking to your spouse about these decisions will add a whole new dimension to your relationship as well as your finances.

You can use the attached Excel spreadsheet to determine your emergency savings goals. 

Click on the link to open Emergency Fund Calculator

What Is your/will Your Emergency Fund Savings Target Be?