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Try tax-exempt bonds for emergency fund

Dear Money Matters,
Would a short or intermediate tax-exempt bond fund be a good place to have money for an emergency fund for an investor in the 28-percent tax bracket?
Gregory

Dear Gregory,
First off, props to you for having the foresight to create an emergency fund. It's something that many investors -- including some who are rather financially savvy otherwise -- overlook, but it's essential to put at least three to six months' worth of living expenses away. That way, should the unforeseen happen -- a car accident, perhaps the loss of a job -- you still have enough money to see you through the first few months.

Your question is actually a central point of debate in many financial circles. Put another way, is it better to take taxes into consideration when choosing an investment or are you better off finding the best investments and letting taxes take their own course?

In your case, you provide part of the answer by saying you're in the 28-percent tax bracket. In turn, we plug that information into a simple formula to determine how a tax-free return compares with one that is taxed.

First, we find the going return of the investment in which you're interested. I found one intermediate tax-exempt bond fund that returned 9.6 percent in 2000 and 5.3 percent the following year.

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From there, all we have to do is take that return and divide it by one minus your tax bracket. I'll show you what I mean -- in the case of the 9.6 percent return, the formula returns 13.3 percent (that's 9.6 divided by .72). That means the equivalent taxed return would be more than 13 percent -- not bad at all. Similarly, 5.3 percent tax-free comes out to 7.36 percent -- not as good, but still nothing to dismiss entirely.

So, on the surface, I would think that a tax-free bond fund in your bracket makes good sense. Another thing to consider is local and state taxes. Depending on where you live, some tax-free bond funds are exempt from state and municipal taxes as well. The primary downside is that bond funds -- like most any other kind of investment -- are not ironclad winners (for instance, the fund I mentioned above lost 1 percent in 1999).

If you don't mind a bit of volatility, then these funds may be a suitable place to stash your emergency cash. Others, however, don't want to put their emergency funds in any sort of danger and opt for safer, but lower-paying returns such as money market accounts. It all depends on what you're willing to put on the line in exchange for a potentially larger payoff.

-- Posted: March 27, 2002

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