||Ask Dr. Don
Emergency fund yields
Dear Dr. Don,
I currently have $16,450 (three times my monthly
take-home pay) in my savings account as a reserve fund in case of
emergency (i.e. loss of job, extended illness, etc.). It is earning
a paltry 0.6 percent interest. Obviously I would like for this money
to work a little harder. What options are available to me that would
provide me with a decent return, yet not be so restrictive that if
I should need to access this reserve, I don't end up paying large
Martin A. Mass
It's a classic conflict inherent to investing an emergency fund.
You want the money to be readily accessible, but hate earning money
market rates on an investment you hope to never need to cash in.
There are several potential solutions, but you need
to keep in mind that by searching for yield (return), you're taking
on some measure of risk. I'll discuss two alternatives.
Certificates of deposit are an easy choice. With an
FDIC-insured deposit, you're not facing any risk to principal; you
just have to be willing to pay any early withdrawal penalties if
you redeem the CD prior to its stated maturity. Make sure you understand
the terms of the deposit, including early redemption penalties,
before investing your emergency fund in CDs.
The idea behind this approach is that the increase
in yield compensates you for the risk of paying an early withdrawal
penalty. Giving back three months' worth of interest earnings is
OK if you've earned five times the yield over what your savings
account pays in interest.
Using Bankrate's Highest
Yield feature for CDs, I found six firms today offering a 2.5-year
CD yielding over 3 percent annual percentage yield. With the low
rates in the current interest rate environment I'd be reluctant
to recommend five-year CDs yielding over 4 percent, but you could
consider building a laddered CD portfolio that had monies invested
in different maturities. Bankrate's "How
to Ladder CDs" discusses how to build a laddered CD portfolio.
helps you learn how to maximize returns with CDs.
Banks also offer "liquid CDs" that allow
some penalty-free withdrawals from the account but pay a lower interest
rate than the same-term CD that isn't penalty free.
U.S. savings bonds used to be an easy choice, but
now, along with three-month interest penalties for early redemption
in the first five years of ownership, the government requires a
minimum holding period of one year.
If you've got some measure of flexibility in your
investments, however, you can invest in savings bonds and, as they
pass the one-year mark, count them toward your emergency fund savings.
Allocating these 1-year-old savings bonds to your emergency fund
allows you to move money from your savings account into longer term
investments. This approach takes some time to put into effect but,
with Series EE bonds currently yielding 2.61 percent and Series
I bonds yielding an inflation-protected 2.19 percent, you'll be
on your way toward improving the yield in your emergency fund. (Yields
change every May and November.)
You can defer until redemption or maturity the federal
income tax due on savings bond earnings. The earnings are also exempt
from state and local income taxes. The Savings Bonds for Education
program also may provide you with the ability to buy bonds for an
emergency fund in your name and use them later to fund education
expenses. Use the savings bonds to fund qualified education expenses
and the interest income is free of federal income taxes. There are
income restrictions on who can use this program.
Bonds Owners Manual is available online and provides all the
background you need to decide if it makes sense for you to move
your emergency fund to savings bonds over time.
-- Posted: March 4, 2004