Having money for those rainy-day events is crucial for Americans and their financial situations.
But most Americans have a hard time funding an emergency expense. A recent GOBankingRates survey found that 57.4% of Americans have less than $1,000 saved for emergencies. A separate Bankrate.com survey found that 39% of adults in the U.S. wouldn’t be able to cover a $1,000 emergency expense using savings, a statistic that’s held steady since around 2014.
While the last 15 months led to better savings habits and more disposable income than pre-pandemic among some adults with higher income, those living paycheck to paycheck are still not adequately saving.
For many people, saving for an emergency fund is the first step toward financial wellness before saving for retirement. Taking care of that emergency fund is crucial, because if you don’t have that and something happens, you could fall into debt and have things snowball.
You’ve been told that you should always have roughly three to six months’ worth of living expenses in your savings account in case something happens. But maybe you don’t have enough cash to put aside today, or maybe you don’t want six months’ worth of cash just sitting in an emergency fund.
For those people, there are creative ways to have an emergency fund. The four I’m going to tackle in this article are: Roth IRAs, health savings accounts (HSAs), utilizing your home equity and considering smart ways to use credit cards.
The Roth IRA
Roth IRAs are a really interesting emergency fund vehicle because your contributions into a Roth IRA go in after tax, and you can access them at any point without negative tax consequences – from both the income tax and penalty tax standpoints.
You really have two parts of Roth IRAs: first, you have the tax-free investment growth portion (but this is only tax-free if you meet certain holding period requirements and triggering events); then, if you need to tap into Roth IRA funds for an emergency, you could tap into the other part – your contributions – without facing an additional tax penalty.
Some important considerations when utilizing Roth IRAs as emergency savings vehicles: It’s not as easy to put money back into a Roth IRA once you’ve taken it out. While you might be able to repay within 60 days as a rollover, you can only do one of these IRA-to-IRA 60-day rollovers a year (every 12 months) across all of your IRAs.
When you do withdraw, try to take out only your contributions – and not earnings – to avoid penalties. Investment growth in a Roth IRA could be subject to both income taxes and a 10% early withdrawal penalty tax if distributed within five years of the account and you are under age 59½. In other words, limit the amount you withdraw to cover your emergency to the amount you’ve put into your Roth IRA.
You should also consider your underlying investments in your Roth IRA. If you can ensure a portion of your Roth IRA is not invested in anything volatile, it can function as a better emergency fund. For instance, if you are invested heavily in growth stocks and you have to sell stocks during a volatile time when you also have an emergency, it might impact you negatively, or you might not have enough money to meet your emergency needs if the stocks pulled back too much. Instead, you may want some portion of your investments in bond funds or another less risky asset if your Roth is also doubling as an emergency fund.
The HSA
For many people, emergencies can often come in the form of unexpected health care events. In such events, you could tap into a health savings account (HSA). Your HSA can serve as a nice emergency savings vehicle because the money held within it can be invested for the long run, but still be accessible if you have qualified health care expenses.
First, I want to note that many people use HSAs incorrectly – or not in the most efficient manner. They use them like flex spending accounts (FSAs), putting money in and taking all of it out the same year to pay their deductible in a high-deductible health plan. In this situation, the HSA provides a tax deduction for the amount you put in, up to the annual limit ($7,200 for a family in 2021). However, what you give up is the tax-deferred growth, as you can invest that money, and the tax-free investment gains you receive if spent on qualified medical expenses in the future.
But if you’re contributing into an HSA, the biggest benefit is actually achieved by investing inside of the HSA and letting your investments grow tax-free – not the tax deduction in year one. Look at your HSA as a retirement health care savings vehicle, not just as a way to deduct your deductible for the year.
Realistically, HSAs are great long-term savings vehicles because of the triple tax play – you get a deduction up front, tax-deferred growth and you can use the money for your unexpected, qualified health care expenditures income tax-free.
Use these vehicles more strategically and efficiently as part of your savings plan both for future planned retirement health care costs and as a buffer for emergency health care costs.
Your Home Equity
Some people might not be comfortable with this one, but tapping into your home equity by utilizing a line of credit or other lending strategy can play an important role in your emergency savings plan.
One strategy is to set up a home equity line of credit (HELOC). Some HELOCs can be set up with little or no upfront costs. Instead, costs kick in when you actually borrow from the HELOC and tap into the line of credit. This strategy gives people the flexibility to borrow if or when an emergency occurs, without having a negative impact on their investments or cash flow if they don’t need the money. However, remember that once you borrow from the HELOC, you’ll have to repay the loan and will accrue interest on the debt – which could snowball if not managed.
A lot of people use lines of credit for home remodels, like in instances when a tree falls and damages the house and maybe insurance will cover it, but you still need to come up with additional cash. Or you have a $500 deductible for the homeowner’s insurance that you need to cover.
Think about your home as an asset and ways you can leverage it to be a potential emergency fund vehicle, if needed. But before you start borrowing for your emergency fund, be sure you can repay it and that you understand the costs of borrowing.
Your Credit Cards
Another borrowing strategy can ease the amount of cash you keep on hand for emergencies. I personally think of my emergency fund as including credit cards, so I probably keep less cash in the short term because I know that if I have an emergency, utilizing my credit cards is an option. However, this strategy works better if you have a stable amount of income coming in each month so you can keep up with your credit card payments.
Obviously, the risk with this option is high: If you run into an emergency and, for some reason, you can’t work, it might be difficult to pay back the credit card, which could get out of control. Credit card interest rates are often some of the highest you can incur. In general, it’s best to not carry credit card debt from month to month, but debt can help you get through a tough time or emergency if used wisely.
Concluding Thoughts
It’s more reasonable for people to hold three, rather than six, months’ worth of expenses in cash. However, the downside of saving this much cash is that it’s not invested and not working for you for the long run. While it’s smart to have some amount of cash set aside for a rainy day, you have to figure out what the right amount of savings is for you.
You also have to figure out how to layer in other savings vehicles mentioned in this article in case something unfortunate happens – you lose your job or get into an accident or have a health care expenditure, and you need to come up with a large amount of money. But some of them – like HELOCs and using credit cards – reiterate the importance of building good credit in your name and managing debt.
If you’re having a difficult time figuring this out on your own, contact a financial planning professional who can help determine the best approach for you.