How to fund the emergency reserve

Source: GETTING GOING By JONATHAN CLEMENTS - Six Months of Emergency Cash? Get Real - November 13, 2005

My comments:

In this article, Jonathan Clements is advising us to keep the emergency funds in stocks or stock funds in order to bolster the overall performance of our savings.

His advice is too sophisticated for me. Still, this article is worthwhile to read.

Conflicting financial goals

In case you get hit with a financial emergency, you should keep six months of living expenses in conservative investments (i.e. cash or money market funds) held in your taxable account.

However, having $30,000 sitting in your bank account earning 1% or 2% for many years is absurd, particularly if you're struggling to save for retirement.

Maybe it's time to ditch the advice of a separate emergency fund.

Instead, start with these four steps.

First, think of your emergency money and retirement nest egg as one big pot of money.

Second, build up the savings in your taxable account, using this money to buy tax-efficient stock funds.

Third, allocate at least part of your 401(k) plan or individual retirement account to bonds.

Fourth, set up a home-equity line of credit.

Example

Suppose you suddenly need $15,000 to pay a hefty hospital bill. If stocks are flying high, that's no problem. You can sell part of your taxable account's stock-fund holdings and pay the hospital that way.

What if we were in the middle of a brutal bear market? You would still sell $15,000 of your taxable account's stock-fund shares. But this, of course, seems foolish. After all, selling shares at fire-sale prices isn't exactly smart investing.

With that in mind, you would immediately want to repurchase the stocks in your retirement account, by shifting $15,000 from bonds to stocks. Result: You have maintained your stock exposure, you have lightened up on bonds and you have the $15,000 to cover the hospital bill.

Meanwhile, view your home-equity line of credit as an additional source of emergency cash.

The above strategy should bolster your portfolio's overall performance, because you no longer have a huge wad of money languishing in low-returning investments.

As an added bonus, you will also enjoy a fistful of tax advantages.

For instance, the tax-efficient stock funds in your taxable account shouldn't kick off large taxable distributions and those distributions you do receive will probably get nicked at the long-term capital gains or dividend-tax rate.

These days, that means paying a maximum of just 15% on tax. You will likely also pay that rate if you have an emergency and have to liquidate part of your taxable account's stock-fund holdings.

By contrast, you wouldn't want to pay for a financial emergency by dipping into your retirement accounts. That would be likely to trigger both income taxes and tax penalties, which together might snag 40% of any withdrawal.

That said, retirement accounts can be a great investment vehicle, in part because they offer tax-deferred growth. Thanks to that tax deferral, these accounts are the best place to hold your bonds, including the bonds needed for your emergency-money strategy.

As you probably know, the interest from taxable bonds gets taxed at ordinary-income-tax rates. However, if you stash your bonds in a retirement account, you should amass greater wealth. The reason: You get to defer the tax bill and you can use the money earmarked for taxes to earn additional investment gains.

Even the home-equity line of credit has tax advantages. If you tap the credit line, you should be able to deduct the mortgage interest on your tax return.