Should You Invest Your Emergency Fund?
In the finance community, I broke a huge rule – and I’ll tell you what I did in a minute (depending on how quickly you read).
It all started, with how everything starts for me….I become exceedingly inquisitive (maybe, a bit nosy) about a topic, and I’m like that kid in the long car ride that doesn’t shut the f up – why? but why? why? wHY?! but wHy??
What I was curious about: Why do people say not to invest your emergency fund? Was it something I didn’t do because everyone said not to?
The answer may seem obvious – If your money is invested and you have an emergency, your money is illiquid. And when you have an emergency, you want green papers ready in the palm of your hand.
The curiosity inside me was officially unleashed, and I decided to start probing. Typical. So, I started crunching numbers and by the end of it, I invested half of my emergency fund.
Sounds sketchy…...but before you start a forest fire, hear me out. I have a larger emergency fund than MOST people. Why? Because I got dealt a fairly, shitty hand of cards at age 27: I dislocated a vertebra backwards, and then was diagnosed with multiple chronic illnesses. I was out over $100k out of pocket even with Platinum PPO health insurance. My abhorrence for health insurance runs DEEP, but that’s a topic for another day.
So, this whole “3-6 month emergency fund” talk was cute, but not for me. My emergency fund was for 12 months. That meant I had A LOT of cash on hand. Which, when you factor inflation into the equation, I was losing a good chunk of money on annual basis.
What’s inflation?
Inflation is the decline of purchasing power of a given currency over time.
If you have cash sitting in a savings account, hidden in your walls, hand sewn into a down feather pillow, or stashed under your lizard cage, you’re losing money to inflation.
The historical CPI inflation rate averages 2.5%-3% every year. The consumer price index increased 6.2% from October 2020, according to Labor Department. Ouchies.
Therefore, if you have a savings account earning 0.01%, you’re losing over 2% per year. Even in a high yield savings account (which is repulsive to call it high yield), is currently earning about 0.5%. So, you would still be losing over 2% per year.
Let me show you my investigation process:
My emergency fund was sitting at $30,000. At the time when I was crunching the numbers, I was looking at how after one year, the purchasing power of $30,000 would actually be more $29,100. This was assuming inflation at 3%. This meant that after two years, my money would be worth more like $28,227. Year 3, $27,380. And it’s downhill from there.
Let’s just say this was the bare minimum math I needed to do before realizing I was losing too much purchasing power, FAST.
Knowing I’m aroused by numbers, I did more math. I wanted to see if I didn’t have a need to use my emergency fund for one year, three years, five years, how much I would be missing out by not investing HALF of my emergency fund. And of course, this is assuming that I’m lucky enough to not have an emergency in 1-5 years. There’s risk involved in that, but I had to see if the the numbers were worth the risk.
Option 1: Put all of my Emergency Fund in a High Yield Savings Account
I calculated that if I left $30,000 in a high yield savings account earning a pathetic 0.5% interest, that in 5 years my $30,000 would become $30,758. And that’s not even accounting for inflation.
Earnings in a high yield savings account are reported as income. Therefore, they are also taxed as such. Given that my marginal tax rate at the time of this calculation was 24%, I would have paid $182 total in taxes over 5 years, which is approximately $36 per year.
Therefore, my true net gain (still not accounting for inflation) was $576. NOT GREAT.
Option 2: Invest half of my money in a taxable brokerage, and leave half in a high yield savings account
By savings $15,000 in a high yield savings account, I am basically earning jack shit. And that’s fine.
With 0.5% interest, in 5 years, my money would grow to $15,379 (not accounting for inflation).
And because of taxes, I’d pay $91 of that $379 gain back to Uncle Sam, which is approximately the same cost as Hulu with ads ($8).
That means in 5 years, my high yield savings would earn me $288, but still lose purchasing power.
That’s where I took $15,000 and considered investing half of it in a taxable brokerage account. Now remember, with a taxable brokerage account, any withdrawal within less than one year, I would be responsible for paying short-term capital gains tax. Short-term capital gains tax is taxed at your ordinary income tax rate.
This means any assets I sell in less than one year, I’d pay a whopping 24% on the gains (you would need to consider your own tax bracket).
Assuming I don’t have an emergency in less than one year, I would then pay long-term capital gains rate, which for most people would be 15%.
Below are the 2021 tax rates for capital gains to help you figure out how much you would pay if you sold your assets in less than one year (short-term) versus longer than one year (long-term).
Source: IRS
Back to Option 2…
By investing $15,000 in a taxable brokerage, assuming an 8% annual rate of return, in 5 years my money could grow to $22,040. If I were to have an emergency and need this additional $15,000, I would pay approximately $1,056 in taxes because of long-term capital gains rate.
The maths: $22,040-$15,000 = $7,040 * 0.15 = $1,056
Therefore, my net gain over 5 years could be $5,984 in the taxable brokerage. It made sense for me to take the risk for a $6,272 potential gain ($5,984 in the taxable brokerage + $288 in the high yield savings account) over 5 years, versus $576 solely in a high yield savings account.
So, I made the call to invest half of my emergency fund.
I have a rather high risk tolerance for someone who trips while standing and wakes up naked after taking NyQuil.
Ultimately, I had to bet with myself that if I had an emergency within less than a year, that hopefully $15,000 would be enough to cover it. Anything over a year, and I would be grateful that I invested and made a return on that investment.
Now of course, this is assuming that things don’t go pear-shaped and the market crashes when I have an emergency. Because, of course, there is the chance that I won’t earn 8% on my money. I could lose money. But this was a risk I was willing to take knowing that ALL of my emergencies thus far (which is a lot), have not required me to need more than $15,000 all at once.
Disclaimer: I am NOT telling you to invest any of your emergency fund. I am simply sharing what happened when my brain started asking rapid fire questions, and what I ended up doing because of it.
This is a personal decision based on my own risk tolerance. Yes, investing can be risky, but losing to inflation seemed riskier to me.
The bottom line: Your money is not locked up in a prison in a taxable brokerage account. You can sell your assets and get your money out if you need it with no penalty, just some taxes to Uncle Sam (the Uncle no one likes).
