Where's the best place to put our emergency fund?

-- Posted: Oct. 4, 2000

Ask the Dollar Diva
By Dorothy Rosen • Bankrate.com

Dear Dollar Diva,
I have a savings account at a local bank for emergency savings. It only earns 2.1 percent interest. I know it's important to have three month's salary saved in case we're out of work, but three months salary for us could be $40,000-$50,000. There have to be better investment options available.

I would like to know your thoughts about money market accounts, or other options available for our emergency savings. It just seems there should be a better place to put these savings than a 2.1 percent savings account.

The rule of thumb is to have savings equal to three to six months of bare bones living expenses to tide you over should you find yourself temporarily out of work.

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For most people bare bones is food, housing, utilities, transportation, insurance, medical, clothing for growing children and a small allowance for personal expenses. If private school and summer camp are essential to you, include them in the bare bones budget, too.

Once you've crunched the numbers and know how much you need to save, you need to find a better place than your savings account to stash the cash. The Diva will help you look at some options.

Money market accounts

Money market accounts are savings accounts offered by banks and credit unions. They are convenient, extremely safe (insured by the Federal Deposit Insurance Corporation or National Credit Union Administration), and offer a higher return than a regular savings account. The average rate last month was 4.44 percent. For today's rates, go to Bankrate.com.

For the rules on minimum balances, monthly limits on withdrawals, and penalties you'll get slapped with if you break them, read Bankrate.com's "The benefits of discipline: Money market accounts reward thrift."

The Diva prefers other savings vehicles over money market funds to money market accounts, and explains why below.

Money market funds

Money market funds are mutual funds sold by the same folks you buy your stock mutual funds from, such as Vanguard, Fidelity and Janus. They offer a better rate than money market accounts; 4.84 percent was the average for taxable MM funds last month. For today's rates, go to Bankrate.com.

Although they're not insured, they invest in low-risk securities, like federal and state debt, so they're super safe. You pay a dollar a share, and although there's no guarantee, you can expect to sell them for a dollar a share. But they are mutual funds, and you do have to read the prospectus so you know exactly what the fund's about, including what it's investing in. You want a no-load fund with low fees (expense ratio of under 1/2 percent).

They come in taxable and tax-free varieties. The average rate for tax-free money market funds last month was 3.04 percent. That's equivalent to a taxable 4.41 percent if you're in the 31 percent tax bracket; 4.75 if you're in the 36 percent bracket.

For more on the nitty gritty of money market funds read Bankrate.com's "Money market mutual funds aim for liquid cash, temporary savings."

A money market fund is a good place for short-term savings, and will work if your job situation is shaky, and you expect to tap into your savings within the next six months. Otherwise long-term certificates of deposit or U.S. Series I bonds should give you a better bang for your buck.

Certificates of deposit

Certificates of deposit are savings accounts that have a fixed term, generally from three months to five years. They're FDIC insured, and convenient because they automatically rollover into another CD at maturity. They pay more than money market funds; the average three month CD currently pays 5.17 percent; the average 5-year CD, 6.36 percent.

There can be hefty penalties for early withdrawals, and interest is taxable as it's earned. For these reasons the Diva thinks Series I bonds might be a better option for high income taxpayers.

Series I bonds are a new gift from Uncle Sam. They are U.S. Savings bonds, that are adjusted every six months for inflation. Interest at this writing is 7.49 percent. Go to U.S. Treasury for the current rate.

You can't touch them for six months, and if you redeem them before 5 years, the penalty is three months interest. It's still a good deal.

The Diva recommends starting your savings in a money market fund, and buying the I bond's in $500 or $1,000 denominations over a 6-month period. That way you'll always have access to cash for living expenses in case of an emergency. You're allowed to buy up to $30,000 worth of I bonds each year.

One sweet feature of the I bonds is, you don't pay tax on the interest until you redeem the bonds. For someone making $160,000 to $200,000 a year, tax-deferred, compound earnings is money in the bank. And if you do have to redeem them because you've lost your job, you may be in a lower tax bracket that year. For more about Series I bonds, read the Diva's "Do Series I Bonds belong in my portfolio?"