The Best Place to Put Your Emergency Savings is a ROTH IRA

by AJTrenkle on Wednesday, February 27th, 2013 | No Comments

As a part of my savings goals, I was trying to figure out the very best place to put the emergency savings fund that I have been building up. The options included:

1. Contributing more and more money to my Capital One 360 (formerly ING DIrect) account where I receive a very good interest rate considering the current climate.
2. Putting the cash in a money market mutual fund
3. Putting them in very conservative stocks
4. Putting them in very conservative bonds

With emergency savings, the essential characteristic is that one have fairly easy access to the cash, at least within the 30 days or so that it would take before a large credit card bill had to paid off. Also, protection of principal, or the initial amount of the money, is critical as well as you would not want your savings drying up because of some unanticipated market shock. That being said, however, the very idea of an emergency as that it should be rare and hopefully never happen. If that is indeed the case, then one should consider return on investment as a part of the equation as you would not want your cash just sitting there, slowly eroding over the years in some extremely low interest checking or savings account.

Each of these options had some strengths, Capital One 360 and the money market funds both provided somewhat less than terrible returns with pretty much complete safety and great liquidity. The stock and bond funds offered the potential to grow the investment and experience the magic of compounding returns, with strong liquidity, but at the risk of having bad timing with a market downturn when I would need access to the cash. This risk is not to be ignored, as of course the most likely time to have high unemployment and risk of job loss is during a recession when the market is in a downward spiral.

Ultimately, though, I have decided to put most of my emergency savings in a ROTH IRA that is conservatively invested in a mix of stocks and bonds. I still will keep at least 1.5 months worth of living expenses in my Capital One 360 account.

I think a ROTH IRA is best mostly because the distribution or withdrawal rules are much friendlier since you contribute to it after paying income taxes on your money. This means that there are no tax savings when you contribute but ehre is much greater flexibility on withdrawals. You can withdraw your full contribution amounts at any time you like. This means if you have contributed $15k over 5 years, and you need the money in the sixth year, you can withdraw up to the full amount of the original contribution, in this case the full $15k. You cannot withdraw any growth or earnings until age 59 1/2 or unless there is a qualifying distribution in a number of financial hardship scenarios. This may seem to be a downer but the most serious of all reasons why you would need to withdraw your retirement savings, like disability or medical issues, are all qualifying events. That means in those cases you can in fact withdraw the earnings as well.

The best part about this system is that you get the growth of stocks and bonds, with hopefully a good margin of safety even if the market is down. Interestingly, while it would obviously be a bad thing to have your portfolio lose value, this would mostly be value (hopefully) lost off of your gains, not your original contribution thus giving you some protection. More importantly, hopefully, you avoid these serious calamities of life, and along the way of saving for a rainy day you have actually gone ahead and saved a lot for your retirement as well. It is a very friendly rule that your earnings can stay in the account and not pay a penalty even if you withdraw the contribution. It is as though your contribution has spawned children and those children can go on and continue to compound without the parent.

As the saying goes, the greatest risk is not taking one, and simply leaving your money to sit in a low interest cash account is not a great move for your finances. That being said, your emergency fund needs to be safe and accessible. With a little bit of money in cash, and the majority of your emergency fund in a ROTH IRA, I believe the average person can have the best of both worlds.