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Ask Dr. Don

Emergency-cash stash

Dear Dr. Don,
Would a short or intermediate tax-exempt mutual fund be a good place to have money for an emergency fund for an investor in the 28-percent tax bracket?

Dear Gregory,
Most financial planners recommend that households should keep three to six months of expenses in an emergency fund for short-term cash needs.

Conventional wisdom suggests that you don't want any liquidity risk in an emergency fund because if you have to sell the investments in a hurry, you may have to take a loss on the investment.

The problem with that advice is that you end up holding a lot of low-yielding cash investments on the odd chance that you'll need that money. See this Bankrate article for additional thoughts on the wisdom of establishing an emergency fund.

I'd rather see you put your emergency fund money into savings bonds than a municipal bond fund. The Series I and Series EE savings bonds charge a three-month interest penalty if you redeem the bonds within five years of purchase, but you don't have to pay state or local income tax on the bonds and you can choose whether to pay federal taxes at redemption/maturity or annually.

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There are no account fees, no transaction costs and you may be able to use the bonds later to pay for college expenses and not pay federal income tax on the interest income. There's also no risk to principal, which is important in an emergency fund.

See if you can readily tap your home's equity, get a loan from your retirement account or cash-value life insurance policy, or get a margin loan against your taxable investment portfolio. Any of these lending sources will reduce how much you need readily available in an emergency fund.

Other things you should consider for emergency preparedness: disability insurance, major medical coverage, a durable power of attorney and an umbrella liability insurance policy.

If you invest in municipal bonds issued by a government unit in your state of residency, the interest income is often exempt from state income taxes as well. Your broker or mutual fund representative will be able to tell you if the interest income is tax exempt in your state, or review this investor guide.

The higher your marginal tax rate, the more sense municipal bonds make in your portfolio. A 28-percent marginal federal income tax rate is high enough to consider municipal investments, but it's not high enough to categorically state that municipals are right for you.

The litmus test for investing in municipal securities is to compare the taxable equivalent yield on the municipal investment with the yield on a taxable investment with similar risks.

Municipal yields are often compared on a tax equivalent yield basis with U.S. Treasury securities. That's not an apples to apples comparison because the U.S. Treasury securities have no default risk, but it's a reasonable approximation when a municipal bond is rated AAA or AAA insured. Use this calculator to find the taxable equivalent yield on your municipal fund.

The problem with using after-tax equivalent yields when deciding to invest in a municipal bond fund is that realized capital gains are taxable vs. the tax-exempt interest income.

Also, when you buy a municipal bond fund, you don't know what the fund will yield, unlike when you buy individual bonds. One advantage to a bond fund besides professional management is that transaction costs in the bond funds are minimal compared to the costs associated with trading individual bonds.

-- Posted: Nov. 14, 2001

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See Also
Trim the fat off your finances!
Creating a 'spending plan'
Building your emergency fund
Where do I stash my emergency cash?

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