By Jamie Hopkins, Esq., Associate Professor of Taxation, The American College of Financial Services
Clients planning for retirement often need assistance from a financial advisor in the area of risk management. In addition to helping clients with the usual list of suspects-diversifying their investments, examining their spending habits, and purchasing insurance — you may want to take a closer look at the development of an emergency fund.
Maintaining an emergency fund is a basic financial planning concept, but today’s low interest rates are forcing changes to traditional strategies. Most of your clients probably use their savings and checking accounts for dual purposes. First, it enables clients to pay ordinary monthly bills, and secondly, it serves as a convenient place to keep extra money on hand to serve as an emergency fund. The bank is easily accessible, the money is usually safe because of deposit insurance, and the bank may even pay some interest. However, today there is practically no return for stashing that extra cash in a savings or checking account. Your clients do get the safety of bank-held money but get no real returns, especially once inflation is considered. Additionally, conditions could be getting worse as some banks around the world are now charging negative interest rates. So you have to ask yourself, with many U.S. savings accounts paying close to 0% interest, is it possible to determine a better location for your client’s emergency fund, or are they stuck with 0% returns?
When building an emergency fund you are generally looking for that winning combination of safety and liquidity. You want the assurance that the money will be there when your clients need it, and that they can get to it quickly. This is what made savings accounts with a bank, savings and loan, or credit union so appealing, and it is why so many people gravitate towards cash or cash equivalents for emergency funds. Some people use money market mutual funds (MMMFs) as an alternative to savings accounts. However, both the savings accounts and the MMMFs tend to pay extremely low interest rates precisely because there is little to no risk, and there is a high level of liquidity or ease of access to the funds.
Does “Emergency” Equal “Immediately”?
For an emergency fund, people are often willing to sacrifice on the returns side rather than compromise on the safety and liquidity side. Usually, to generate higher returns, the client will likely have to give up either safety, liquidity, or both. With emergency funds, the client is probably more inclined to sacrifice liquidity, rather than taking on more risk to get a higher return. Emergency funds really should not be invested in risky assets. Also, most of the client’s emergency fund liquidity needs are likely perceived and not real. For instance, if an emergency need does arise, the client often does not need money that day. Actually, the client may not need it for a month or two in order to pay the bill once it arrives. As such, most people do not need a large emergency fund that can be tapped into immediately; they just need an emergency fund that can be tapped into relatively quickly, say in a few weeks or months.
So where can you get better returns for your clients and keep some liquidity? First, consider having clients’ money do double duty, such as be part of retirement savings vehicle and provide emergency relief when needed. The Roth IRA is a savings vehicle that can be used for an emergency fund both before and during retirement. Once your client puts money inside of a Roth IRA, it can be invested it in a wide range of options, including individual stocks, bonds, bond funds, money markets, or mutual funds. Depending on your client’s risk tolerance and desired returns, investments can be selected with varying degrees of risk. Because of the nature of an emergency fund, you might be looking for less risky investment options inside the Roth than you would otherwise consider for building a traditional retirement portfolio. While the Roth IRA may not provide the instant liquidity of a savings or checking account, it can still provide access to funds within a few days, often well before any payment for an emergency need would actually be due. Also, the tax rules allow the client to withdraw his or her contributions first, giving tax-free access to contributions at any time. However, to get access to the investment gains prior to age 59.5, your client will generally have to pay both income taxes and a 10% penalty tax on earnings that are distributed.
Another savings vehicle that certain clients may find helpful for creating a small emergency fund is the myRA. The myRA is a retirement savings vehicle created by the Federal Government to help those individuals without access to a 401(k) or other employer-sponsored retirement plan. The myRA operates like a Roth IRA, but has no fees to eat away at the investment returns. The only investment option is a very safe and secure United States Treasury savings bond that will pay higher returns than your client will get in a savings account or with a MMMF. The one-year return as of August 2016 is 2.06% for the government bond. The principal is not guaranteed, but since the fund invests in short-term notes, there is little risk of a loss in value. Typically, the myRA savings bond will also outpace inflation, meaning you are actually growing the investment in real dollars. While the myRA is a new savings vehicle, it can be a good opportunity for people wanting to set aside $5,000 or $10,000 for an emergency fund. It allows them to maintain liquidity, increase their returns, get preferential tax treatment, and keep the risk of their investments down.
Whether you use a traditional Roth IRA or a myRA to create your client’s emergency fund, both offer preferential tax treatment on any investment gains. As long as the account is maintained for five years and the client attains age 59.5, the investment gains come out of a Roth IRA or myRA income tax-free, unlike interest paid on a savings account which counts as taxable income each year. Roth IRAs can also function as effective emergency funds during retirement because they are not subject to the required minimum distribution rules that apply to IRAs and 401(k)s beginning at age 70.5. This means the money can be used in retirement when the client wants to use it, and not when federal law requires him or her to withdraw it. Additionally, once a year your client can take money out of a Roth IRA and put it back into the same Roth IRA within 60 days. This basically allows short term access to the money. However, if the money is not paid back within the 60-day repayment deadline, it will be considered a distribution, in which case the money cannot be re-deposited into the account.
Additional Savings Strategies
Another strategy is to shop around for banks. While many banks are paying very low interest rates, some are paying interest rates of almost 1%. While 1% might not seem like much, it is substantially better than getting 0% interest or having a negative interest rate. But, remember that these rates will change over time.
Dr. Walt Woerheide, Professor of Investments at The American College of Financial Services, has noted that yet another way to think about emergency funds is to have an established borrowing capacity. Borrowing capacity can take many forms. One of the cheapest is a home equity line of credit (HELOC). Another would be the use of margin loans on an investment account. Probably the most expensive form is borrowing on a credit card. However, using loans or other such vehicles as an emergency fund works best when you are confident that the client will have other sources of cash to repay the funds in the near future.
In today’s low interest rate environment, searching for the right savings vehicles and investment options for clients can be very challenging when trying to maintain and protect an emergency fund. Roth IRAs and myRAs can be valuable tools in creating an emergency fund that pays higher returns, but neither can fully replace the need to use a savings or checking for clients’ daily and weekly cash needs, even if the interest rates are not ideal. Also, remember to take some time, review your clients’ spending habits and cash flow needs to determine how large of an emergency fund they might need. Once you have done that, you can then work together with your clients to find a more suitable location for the funds.
Get more information on providing your clients with solid retirement planning advice by reading “The Guide to Being a Successful Retirement Income Planner.”