Do you really need an emergency fund?

"I look at emergency reserves as insurance, not (as) an investment," says Rick Kahler, a Certified Financial Planner in Rapid City, S.D. "So to that end, the most I may do with the funds would be to go with an ultra-short fund, CD or short-term bond fund. Anything beyond that leaves the spectrum of insurance and becomes an investment."

McBride also suggests looking at federally insured online savings accounts, which not only pay a bit better than conventional banks, but also tend to respond more quickly when interest rates rise. One caveat: It can take a day or two for an online account to transfer money to your checking account for spending, which could be a problem in a truly urgent emergency.

As to losing ground to inflation, McBride considers that a weak argument. He points out that safe investments almost always lag inflation, even in times when interest rates run higher.

Your backup resources

Your emergency fund may be your first line of defense, but in case you exhaust it, you'll want to know what other assets you have to draw on.

Mutual funds and other investments. Any investments you have outside of your retirement accounts are also fair game in an emergency. The risk, of course, is that your personal emergency will inconveniently coincide with a market meltdown like we experienced in 2008, and you'll be forced to sell at the worst possible moment.

Roth IRAs. Unlike traditional IRAs, a Roth allows you to withdraw your contributions whenever you wish. For that reason, Adam says, they're her favorite way to save, "especially for young adults who are starting to save for retirement. You can always take your contributions out without tax or penalty if you have a true emergency. But if you don't, the money stays in the account, grows and is forever tax-free."

Home equity. A home equity line of credit, or HELOC, which you'd open but plan to use only in an emergency, is another handy option. Many financial planners say the time to get one is before you face a crisis because they can be harder to qualify for if you lose your job, for example. Closing costs tend to be modest or even waived, and interest rates are less than exorbitant (currently under 5 percent on average).

However, McBride cautions that HELOCs may not be a sure thing. In the recent financial crisis, he notes, some banks either froze or simply cut off some customers' home equity lines, leaving them without the credit they thought they could depend on.

Your 401(k) plan. You might also be able to take a hardship distribution or loan from a 401(k) plan, though neither of those is a move to be made lightly. In the case of a hardship withdrawal, you'll face taxes today and have less saved for retirement tomorrow. And if you take a loan and then leave your job, you may be required to pay it back in full, or incur tax penalties.

Last resorts

Finally, there are some financial resources you should do your best to avoid touching, unless you have absolutely nowhere else to turn. Those include your traditional IRAs and credit cards.

Any traditional IRA withdrawals you make before age 59 1/2 will generally be subject to income taxes plus a penalty of 10 percent on the amount withdrawn, though you can receive a penalty exemption in limited cases. Perhaps the biggest drawback is that you'll no longer have that money for your retirement years, where future financial emergencies may await.

As for credit cards, they might be the worst of all possible ways to cover a financial emergency. With average rates exceeding 15 percent for many types of cards, they could quickly get you into an even bigger mess.


Show Bankrate's community sharing policy
          Connect with us

Ask Dr. Don

Use bonds for school, avoid tax?

Dear Dr. Don, This is a bad news, good news situation that I'm asking about. I just received several Series EE and Series I savings bonds. I am the so-called payable-on-death beneficiary on the bonds. My mom, who purchased... Read more


Connect with us