Abstract:

After saving 1 month’s income in a checking account to automate your finances, you should save 3 months’ expenses as an emergency fund requirement.  To maximize your net worth, invest that emergency fund in a Roth IRA or taxable account and pad it to ensure no market crash jeopardizes your emergency fund requirement.

Bank Account Buffer

Your first savings priority is to save one month’s income in a checking account.  These savings prevent you from living paycheck to paycheck and enable you to automate your finances through monthly autopay without risk of overdraft fees.

Assuming your monthly cash expenditures and investments are less than one month’s income (you can’t spend or save cash you don’t have), keeping one month’s income available at the end of each month ensures your checking account balance will never fall below $0.  Even if you overspend your budget shortly before the end of the month,  you will not be at risk of depleting your checking account if you are paid biweekly because another paycheck came in to act as your “bank account buffer.”  If you are paid less frequently, you will want to ensure your checking account includes one additional paycheck such as two months’ income for a monthly paycheck.

[Target End of Month Checking Account Balance] = max([1 month’s income], [2 paychecks])

[Bank Account Buffer] = [1 paycheck]

What Checking Account To Use?

When choosing a checking account, you want to consider the following:

1. No ATM or monthly fees.
2. High interest rate.
3. No activity requirement (such as a minimum monthly debit card transaction or online bank account sign-ons).
4. No limit on transactions (which is why I don’t recommend savings accounts which by law require a maximum of 6 transactions per month).

In 2015, Money Magazine named Aspiration.com’s Summit Account the best checking account available.¹ It is still the best I’ve found to date.

The Summit Account will allow you to use any ATM in the world for free since Aspiration reimburses all ATM fees.  It also doesn’t charge overdraft fees and will simply decline transactions that put your balance below $0.  The account also offers very high yearly interest rates for checking accounts: 1% for entire balances that’re over $2,500 and 0.25% for entire balances that’re under that.  Aspiration also donates 10% of their profits to charity.

If your bank account buffer is under $2,500, you should consider Bank5Connect.com’s checking account that reimburses ATM fees up to $15 per month and offers 0.76% interest rates for entire balances that’re over $100.

While a few other banks and credit unions offer higher checking account interest rates, they only do so after requiring a number of debit card purchases each month.  I recommend using credit cards for purchases to earn rewards and protect from fraud.

Emergency Fund Account Options

You’ve already built a bank account buffer, but what if an emergency causes you to need more cash quickly?

Your emergency fund is designed to protect you in the case of a job loss by allowing unanticipated access to cash.

You could tap other accounts:

• A taxable account
  • If you sell investments that have experienced a loss, you harvest a tax-loss and can write this off on your taxes!
  • If you sell investments that have experienced a gain, you may have to pay capital-gains tax of 0-20% on only the gains which isn’t horrible but not ideal.
• A Roth IRA
  • No consequence outside of continued tax-free growth when you withdraw contributions.
• Credit Cards
  • Some credit cards offer 0% interest for up to 21 months, but if you’ve already tapped these offers, you’ll be charged a hefty interest rate using other cards.
• 401(k) or Traditional IRA
  • You’ll be slammed with a 10% early withdrawal penalty on the funds you withdraw.

Of these options a taxable account or Roth IRA are the most palatable.  But these investments are subject to market volatility.

To avoid volatility, most financial advisers recommend always keeping an emergency fund in a checking account.  This is bad advice.

A typical emergency fund of $12,000 earning 1% in a checking account instead of investing it over the course of 30 years before retirement in a solid decreasing risk glidepath allocation of stocks and bonds would cause you to miss out on over $65,000 of earnings!

Safely Investing Your Emergency Fund

Markets may be volatile, but they are also predictable.

You just need to ensure your emergency fund always remains large enough to bridge your likely unemployment gap and minimize the need to tap Credit Cards, 401(k)s, or Traditional IRAs.  The amount of money you need to bridge that gap is known as your “emergency fund requirement.”  To ensure your emergency fund always maintains its requirement, you can pad its invested portion.

By doubling the invested portion of your emergency fund, a 50% market crash would cause those funds to fall back to your emergency fund requirement.  A 50% market crash has happened only twice in history: the great depression and the great recession.²  Even in those cases, it took more than a year for the markets to drop by 50%, which is time you could use your income to build your emergency fund back up if you haven’t already cashed it out to leverage it.

Additionally, the majority of the time your invested emergency fund will be growing larger than your initial target, making this approach even safer.

Building Your Emergency Fund

What if you are still building your emergency fund and don’t have the funds yet to pad it?

Start by saving those funds in a checking account until reaching your emergency fund requirement, then start investing any new savings and an equivalent amount from your checking account into a Roth IRA or taxable investment account until your checking account is left with only your bank account buffer.  This has the benefit of keeping your emergency fund safe as the portion in the checking account experiences no volatility and the portion in the Roth IRA or taxable investment account is padded to minimize the risk from volatility.

For example, if your monthly expenses are $4,000, you have your desired three month $12,000 emergency fund in your checking account, and you have an additional $250 of income to contribute to your emergency fund each month, you should invest the $250 income and an additional $250 from your checking account into a Roth IRA or taxable account each month until your checking account only has one month’s income remaining.

[Target invested emergency fund amount] = 2 * ([Emergency fund requirement] – [Bank account buffer])

As a Roth IRA has capital gains tax advantages over taxable accounts, prioritize your invested emergency fund contributions to a Roth IRA first.

Taxable and Roth IRA Investments are Liquid

But aren’t invested funds not liquid?  They are actually almost as liquid as cash at your bank.

Sure, you can’t run to the ATM and pull out the money in a matter of minutes, but what emergencies actually require cash within minutes?

With Vanguard you can sell investments and get your cash within two business days.³

When Should I Build My Emergency Fund

While building a bank account buffer is your very first saving priority, extending that with an emergency fund comes after a couple other financial priorities.

You should build your emergency fund after:

• Maxing out any employer matches to HSAs or 401(k)s.
  • Employer matches often provide 50%-100% returns that should never be passed up.
• Saving your expected yearly medical expenses in an HSA.
  • Medical expenses simply become cheaper when paying them from an HSA for triple tax savings.
• Paying down credit card debt.
  • Paying down credit card debt comes before saving to help avoid future credit card debt.

How Big Should Your Emergency Fund Requirement Be?

Your emergency fund requirement can keep you from investing in potentially more tax efficient places such as 401(k)s and Traditional IRAs, so you don’t want to make it too big.  The average job search takes just over six weeks according to a survey by Time Inc.  High-level VP jobs can take up to 76 days.⁴

With low job search times and the ability to tap credit cards, 401(k)s, or Traditional IRAs thereafter, I advocate using the low side of recommendations and target a three month emergency fund requirement.

The vast majority of the time your emergency fund will be at least a few months’ expenses bigger as you’ve padded the invested portion which will continue to grow.

Works Cited

¹ http://time.com/money/collection-post/4079857/best-checking-bank-account-aspiration-2015/

² http://www.nbcnews.com/id/37740147/ns/business-stocks_and_economy/t/historic-bear-markets/#.WZd6MFV96po

³ https://personal.vanguard.com/us/whatweoffer/accountservices/banking

⁴ https://time.com/money/4053899/how-long-it-takes-to-get-hired/