Updated January 1, 2020
I've turned a taxable investment account into my emergency fund.
There are a couple of things that I “know” as someone who writes about personal finance for my “job.”
- I'm not supposed to be using a taxable investment account until my tax-advantaged retirement accounts are maxed out.
- And my emergency fund is supposed to be in a liquid savings account with a high yield.
I do have money in a high yield, online savings account. However, I also use a taxable investment account as part of my emergency fund. This is where I come off the rails a bit when it comes to what I'm “supposed” to do.
Why I Use a Tiered System for My Emergency Fund
The key to my approach is a tiered system for my emergency fund. I keep about three to five weeks' worth of expenses in a high-yield savings account. This is money that I can access quickly and easily, at any moment. If it's for something relatively small, like a car repair, all I have to do is move the money into a connected checking account and access that with a debit card.
For longer-term issues, I could move a bigger amount into my checking to tide me over until the investments cleared. I use Betterment (natch) for the invested portion of my emergency fund. It usually takes five to seven business days to get the money into my account from the time I say I want to withdraw. Because the investments have to settle, and then they have to be transferred, it can take some time.
This tiered approach allows me immediate access to cash while I liquidate investments. It works for me because I end up with a higher rate of return with the money in a taxable investment account. For example, I've got a 13.3% cumulative time-weighted return with the taxable investment account, since the beginning of 2010, when my return with my savings account has been 3.6%.
My emergency fund money has made more money because of the performance of the stock market.
How I Started My Emergency Fund
It's important to understand that I started by building an emergency fund in a more traditional manner. I built up my emergency fund using a high-yield savings account. This happened prior to the Great Recession, however, so it was possible for me to earn 4% to 5% APY on my balance.
I actually began shifting to a tiered approach after the stock market crash of 2008. After deciding how much to keep in the savings account, I used a large chunk of the money to buy index funds in early 2009, when everything was on sale. My ability to do so was a lucky chance, just because of the timing. As a result, my account has grown over time.
Today, I keep putting money into the account, making it possible for my portfolio to keep growing.
Edited to add: If you're interested in the idea of a Roth IRA as an emergency fund, as suggested in the comments, check out an article I wrote in 2012 (note the contribution limits are outdated because it's an old article).
Automatic Investment Each Month
In truth, my money is mostly automated. I check in with it regularly, but for the most part things are on auto-pilot. I automate contributions to a cash reserve account, as well as to the investment account. It isn't a huge amount (automatic contributions to my Roth IRA are larger), but it's there. The taxable account was opened years ago, before I really started thinking about the proper “order” to my investing. And I never got around to changing it.
Over time, I move excess funds from my high-yield savings account into the taxable investment account. This works out well because it also means I have something of a cash cushion that can be used to make extra purchases when the stock market drops. When I see a chance to buy something at a bargain, I have the cash for it. The excess in my savings account is often used to make purchases of undervalued assets.
Why this Emergency Fund Approach Works for Me
Several years ago, I withdrew some money from the taxable investment account to help pay for some unexpected expenses. I withdrew during a “down” period. Instead of seeing capital gains, I saw losses. They weren't huge losses, but they were losses. So I had the benefit of using almost $2,000 from that account, and not having to pay taxes on it — in fact, I was able to offset some of my income with the loss.
Even if I had withdrawn at a time when gains would have been realized, the small amounts withdrawn for emergency purposes wouldn't likely have resulted in taxes that were too much higher. I was just barely into a new, higher tax bracket at that point, so it wouldn't have been a huge difference. Plus, I've had the account long enough that any gains would be taxed at the favorable long-term capital gains rate.
Be aware, though, that you’ll benefit during a bull run, especially if you index. It can be tempting to view yourself as an investing genius at these times. I’m not and you probably aren’t, either. You’ll do well when the market is up and lose when the market is down.
Watch Out for the Downsides of Using an Investment Account for an Emergency Fund
Of course, one of the issues with withdrawing from an investment account as an emergency fund is due to the fact that you can't get the money immediately. You have to sell the shares, and it takes a couple of days for the order to clear. Then, once the money is made available to you as cash in your account, you have to transfer it to your bank account, which takes another three or four days. The result is that you don't get the money instantly.
I don't usually need the money instantly, even in an emergency, though. There is usually enough of a buffer involved in my monthly cash flow to allow for a week during which shares can be sold, and for the resulting cash to make it into my account. And, if there isn't enough of a buffer…Well, that's what the high yield savings account is for. It's connected to a checking account (instant transfer) with a debit card.
Plus, there is the risk of loss. You need a strong stomach to deal with the fact that you might end up selling at a loss. Be clear about your goals for the account — access to money when you need it — so that you aren't as shaken when you lose. Remember, too, that the market is likely to recover, so if you don’t deplete your funds, you still have money left to grow later.
Finally, understand the tax consequences of what you're doing. While it might be good to claim capital losses, you also have to realize that there might be some issues with capital gains. Pay attention and try to limit your withdrawals only to assets you've had for more than a year to take advantage of the favorable rate.
It's not a perfect system, of course, but it works for me. I haven't had a problem with it. Money gets set aside each month to help deal with problems, and the money grows at a reasonable rate. And, even if I need to withdraw some of the money during a time of loss, at least I avoid taxes and even get to offset some of my income.
Additionally, you might not be comfortable keeping only a few weeks’ worth in your own savings account. Perhaps you’d prefer to keep three to six months’ worth of expenses in your savings account and put the rest in a taxable investment account. The key is to know your own risk tolerance and figure out if this is the right move for you.
What do you think? Would you use a taxable investment account as an emergency fund?