Your Emergency Fund & Inflation: What You Need to Know — The Life CFO

Do you keep your emergency fund in “high-yield” savings accounts or in money market accounts? If so, I bet you’ve noticed your interest rate dropping like a rock recently. I certainly have.

The interest rates on high-yield savings accounts have dropped from 2.00% over a year ago to 0.60%.

The purpose of an emergency fund is to set aside liquid funds in a low-risk place to use in the event of income loss or an unexpected expense. However, if you think that a high-yield savings account generating 0.60% interest per year is low-risk in this economic environment, think again.

The Federal Reserve is targeting to “average” 2% inflation per year over the next few years. That means that inflation in any given year could well exceed 2% as they work to meet that “average”.

What does this really mean for our savings and emergency funds?

We can use a simple equation to help us answer this question.

The Fisher Equation

Let’s define a few terms before we look at the Fisher Equation:

The nominal interest rate is the stated interest rate on your savings accounts (or on a loan). For our “high-yield” savings account, this would be 0.60%.

The rate of inflation is the rate at which the average price of goods and services is increasing. It indicates a decrease in purchasing power. The most common measure of inflation is CPI.

The real interest rate is the interest rate that has been adjusted to remove the effect of inflation.

The Fisher Equation is a calculation of the real interest rate. The equation states that the “real interest rate” is equal to the nominal interest rate less inflation.

(Nominal rate) — (rate of inflation) = real interest rate

In the case of our high-yield savings accounts, our nominal interest rate is now 0.60%. Using our equation above, if inflation is 2.00%, your real interest rate is -1.4%! That means your emergency fund will only cover 98.6% of what you expected it to cover next year!

The real interest rate goes even further negative if the rate of inflation increases. In addition, you are taxed on your nominal interest earnings (turning your 0.6% nominal rate 0.45% if your tax rate is 25%).

So What Can You Do?

High-yield savings accounts give us liquidity and a low-risk place to store our money. Those are two critical things for our emergency fund. However, we need to protect our purchasing power. And being virtually guaranteed to lose an average of 1.6% annually is not my idea of “low-risk”.

Keep a portion of your emergency fund in a high-yield savings account, but consider moving a portion into a Roth IRA. In the Roth IRA, you can invest in lower risk assets to offset the effects of inflation of your emergency funds. This strategy will work if you are (1) not currently funding a Roth IRA (this is outside of your employer-sponsored 401(k)), and (2) you are not subject to the tax limitations for making contributions to a Roth IRA.

If you are subject to tax limitations for making a contribution to a Roth IRA, this strategy can work in an individual brokerage account. You need to make sure your emergency fund is separate from any other investment accounts). The only downside is that you will be taxed on earnings generated.

How much of your emergency fund should you move?

The overall goal with this strategy is to offset the impact of the negative real interest rate. Building wealth is not our goal with this money. Only a portion of your emergency fund needs to be put into a Roth IRA.

You should have a fully funded emergency fund ( Dave Ramsey Baby Step #3) before moving anything into a Roth IRA. Maintain a minimum of 3 months of expenses in your high-yield savings account. Consider moving the rest to a Roth IRA (subject to annual contribution limits).

If you follow our reserve fund allocation method for calculating your emergency fund, move no more than half of your income replacement fund into a Roth IRA. Again, keep a minimum of 3 months in high-yield savings. If you have room in your annual contribution limits, you can consider moving a portion of other reserve funds into a Roth IRA as well (auto repair fund, house fund, etc.).

Roth IRA Advantages

In a Roth IRA, you contribute up to $6,000 annually of after-tax dollars (referred to as your principal). Investment income is not taxed when you withdraw it in retirement. You can always withdraw your principal without penalty or tax since you were already taxed on this money. This makes it attractive to use for an emergency fund.

In other words, avoiding taxes on interest, dividends and capital gains is the advantage of being able to invest within the Roth IRA

What if you need to pull out your full emergency fund, earnings included?

There is a 10% early withdrawal penalty on top of regular taxes on investment income if you withdraw before retirement. However, you most likely end up with more money after penalties if you choose to invest in the Roth IRA.

To match the interest income you get in your savings account, you would need an annual return of 0.67%. A 10% penalty on 0.67% would leave you with roughly 0.60% return to pay taxes on.

A 0.67% annual return is very modest assuming you deploy a proper asset allocation within your fund.

Investment Considerations

In a Roth IRA, you can buy most financial instruments that you can purchase through an individual brokerage account (money market funds, US treasury bonds, stocks, etc.). I made the decision to keep our funds in low risk items such as short-term treasuries (including TIPS), money market funds and assets that perform well in periods of a down dollar like gold and bitcoin. I attempted to construct a portfolio of assets that will hedge against the risk of inflation, but will also perform relatively well even if inflation is not as high as expected.

Risks

The largest risk is a drawdown on this savings at a time when we need it most. That is why we only put 3 months of our emergency fund into this strategy and not the a full 6 months. This gives some time for the investments to recover. In addition, we are keeping the funds in lower volatility assets (with the exception of bitcoin) which can help us to avoid a large drawdown.

Make it a goal to keep at least 130% of 3 months of expenses saved in the Roth IRA account to give some wiggle room should you experience any drawdowns you are unable to risk manage through.

Another risk to pay attention to is a change to tax law. That could significantly change the benefits to this strategy.

Takeaways

Being aware of inflation changes your risk considerations. Balance the risk of inflation with the goal of preserving and protecting liquidity and you will have a strategy that will sustain your emergency fund for years to come.

Please remember a few key takeaways as you consider using this strategy:

1. Complete Dave Ramsey’s Baby Step #3 by fully-funding your emergency fund before considering this strategy.
2. What I am proposing above is NOT a strategy for your total emergency fund. You should keep a minimum of 3 months of expenses saved in your high-yield savings or money-market accounts.
3. You are adding risk of a drawdown to the money you put into the Roth IRA and invest. To protect against a drawdown, over-fund this portion of your emergency fund. Getting to 130% protects you against a 30% drawdown (not exactly, but the math is close).
4. This is not an account to speculate with — ensure you are investing in lower risk assets or assets that hedge against inflation.
5. Pay attention to changes in interest rates and tax laws around Roth IRAs. Changes to either of these may require a change in this strategy.

Originally published at https://thelifecfo.com on November 12, 2020.