Unconventional Is Better: Don’t Have a “Regular” Emergency Fund

“You need 3 to 6 months of living expenses in a checking or savings account in the event of an emergency.” 

-Almost every personal finance advisor

That advice has been circulating for years and has become a cornerstone of personal finance.

I don’t take issue with the view that you should have funds quickly available in the event of an emergency.  Makes complete sense.

What I don’t like is the almost universally accepted view that you need to put this money into a checking, savings, or money market account because they offer easy access to your funds.  

So what are good unconventional options for emergency funds?

The Roth IRA and the Health Savings Account (HSA) are two unconventional options for emergency funds that may offer more benefits than conventional checking or savings accounts.  

There is a bonus strategy I ran across in my research as well, which I found pretty interesting.  I will get into it later in the article, but it’s using credit card rewards points as an emergency fund. 

Ok, now let’s get started!

This post may contain affiliate links.  If you click on a link and complete a transaction, I may make a small commission at no extra cost to you.

Table of Contents

The Roth IRA

What is a Roth IRA?

A Roth IRA is an individual retirement account (IRA) that allows you to put “after-tax” income into the account, which is then allowed to grow tax-free.  After-tax income is basically the income you have leftover to spend after taxes have been paid.  

After age 59.5, you can withdraw the money without paying any taxes or penalties.

The Roth IRA should be available to anyone who has income from a job or business, so most people can open one up.  

There are some limitations, though.

As of 2021, you can contribute up to $6,000 per year ($7,000 if you are 50 or older).  Your spouse can also contribute up to the same limit, even if they earn no income, but the combined contribution can’t be larger than the combined income.

There are also income limits on who can open up a Roth IRA.  They are $140,000 for 2021 if you are single and $208,000 if you are married.  

But don’t worry if you are above these limits – you can do a backdoor Roth IRA.  

  • Just open up a traditional IRA at your brokerage (I use Fidelity, but you can use anyone). 
  • Then open up a Roth IRA at the same brokerage.
  • Fund the traditional IRA. 
  • Once the funds hit, transfer the entire balance to your Roth IRA.

That’s it.  You can call Fidelity and they can walk you through this step-by-step.  Super easy and takes like 5 minutes.  

If you are more of a visual person, I found this video to be super helpful. 

If you already have a traditional IRA and you want to do a Roth conversion, you can.  Just transfer the assets from your traditional IRA to a new Roth IRA that you open. 

But you will need to pay taxes on any untaxed amounts in your traditional IRA (makes sense since a Roth IRA is only for “after-tax” money). 

Why is a Roth IRA a Better Option For Your Emergency Fund?

All that is just background for the key feature of the Roth IRA that makes it an ideal vehicle to store your emergency funds.  Any contributions you make can be withdrawn penalty-free and tax-free.  At any time.  For any purpose. 

Sounds like a perfect vehicle for your emergency fund.  

I would note that this withdrawal flexibility does not extend to earnings you make in the Roth IRA.  Those earnings may be subject to penalties and taxes if you withdraw them before age 59.5.  And there is a holding period of five years that may apply. 

But all that is irrelevant.

If you put in $6,000 today, you can withdraw $6,000 tomorrow. 

But why is that better than the conventional checking account, savings account, or money market account? 

Two reasons:

First, any gains you make in your Roth IRA are allowed to grow tax-free.  And once you hit retirement age, you can withdraw those gains without paying any penalties or taxes.  

So the Roth IRA can serve double duty as a tax shelter but has just as much flexibility to withdraw contributions.

Second, you have way more investment options in a Roth IRA that you open up at a brokerage firm.  Compare that against the conventional checking or savings account that you have at a bank – all you have in terms of potential return is the interest rate the banks pay you (which these days is almost nothing).

With a Roth IRA, you can invest in a wide range of securities.  Stocks, bonds, mutual funds, and ETFs are all available options.  You can even invest in alternative asset classes like real estate, but that is a topic for a different article.

But isn’t there more risk if you invest in securities?

Yes.  As a general rule, the more potential for return you have, the higher you move along the risk spectrum.  This is called the risk-return tradeoff.  

But I am not saying that you must invest your money in higher-risk securities.  My point is that you can choose to pursue higher returns if you have the risk tolerance for it.  

If you are worried about risky investments, but still want higher returns than a checking account gives, consider looking into a “conservative” fund.  These are funds that consist of less risky assets. 

This article explores some Vanguard funds you can invest in that are specifically geared for conservative investors.

But if you are committed to not risking anything in your Roth emergency fund, you can do that too.  Just keep your balances in cash and enjoy SIPC protection of up to $250,000.  

If at any point in time you want to dip your toe into investing (even on a small portion of your balances), you can do so with a click of your mouse.  In fact, as your Roth IRA grows, you may feel more freedom to invest some small portion of that money in higher yielding investments.

Even if you keep all of your Roth IRA money in cash, you may still earn a very small interest rate.  It will probably be similar to the rate you would earn in a normal checking or savings account at your brick-and-mortar bank. 

But remember – because the money is in a Roth, your earnings will enjoy all of the tax advantages offered by a Roth.  Not much when you are only earning a tiny amount of interest, but it’s still a benefit that your standard checking or savings account can’t match.

One thing to note as well:  If you have not hit your maximum contribution amount for your Roth IRA, you definitely should use the money you were planning for your emergency fund to do that because you get a limited window to fund your Roth each year.  

Don’t lose all the benefits that a Roth can offer that money by following the herd and depositing it into a regular checking account.

A final advantage is a psychological one.  I think if your emergency fund is in a retirement account, you are more likely to view money in that account as untouchable and only to be used for retirement.  

This is important because many people raid their emergency funds for non-emergency use.  If a big chunk of money is just sitting in a checking account, I think the temptation to use it for a great deal on a vacation or some other tempting purchase looms large.  Any mental advantage that you can have to prevent that from happening is a plus.

The Health Savings Account (HSA)

What is an HSA?

An HSA is a tax-advantaged account that some employers offer in connection with a high deductible health plan (“HDHP”). 

With an HSA, you pay your monthly premiums for the HDHP (which are often cheaper than “regular” medical insurance premiums), and you also contribute a certain amount each month to your HSA account.  

You can then use funds in your HSA to pay for qualified medical expenses.  

The downside is that your medical plan requires a high deductible.  So you have to deplete that high deductible each year before the full benefits of your insurance coverage kick in. 

As of 2021, you can contribute up to $3,600 to your HSA ($7,200 for families).  If you are over 55, that number is bumped up by $1,000.  Bear in mind that some plans do not have your HSA funds in an account with investment options (my account, for example, was basically just a cash account).  

I had to open up an investment account that was linked to the cash account and move some of my money to that investment account to start deploying it in better investments, such as stocks, bonds, funds, etc.  

In my case, they also required that I keep a certain minimum amount in the cash account (for me it was $1,000), so I could not invest the whole amount in securities.

Why is an HSA a Better Option For Your Emergency Fund?

The HSA is a better option for your emergency fund because it offers unmatched tax advantages, the ability to invest your money in a broad range of assets, and  the option to double as a retirement account, while still providing a way to readily access funds in the event of an emergency.

That last part is going to blow your mind.  We’ll cover it a bit later, but first, let’s talk about why HSAs are awesome investment vehicles.  

They offer a triple tax advantage which means that your contributions (i) are tax-deductible, (ii) can grow tax-free, and (iii) can be withdrawn tax-free if you use them for qualified medical expenses.

An added benefit is employers may offer matching contributions to your HSA contributions (which is basically free money).  

And an HSA can serve double duty as a retirement account because after age 65, you can use funds in your HSA for any purpose without paying penalties.  

You still must pay taxes on those withdrawals, but that is no different than how a traditional 401(k) or traditional IRA operates.    

If you are interested in learning more about HSAs, I wrote an article about how to really maximize the benefits of your HSA.

Now the feature that allows your HSA to serve double duty as a great emergency fund is the third tax advantage I mentioned above (i.e., no penalties or taxes on withdrawals from an HSA if they are used for qualified medical expenses). 

The wrinkle here is that the IRS lets you reimburse yourself for those expenses at any time.  

So the strategy is to pay for your medical expenses out of pocket (don’t use your HSA funds) but save the receipts for those expenses (I just take a picture and upload it to google drive).   If you ever need to “cash in” those receipts (which can be years later), you can do so by submitting them for reimbursement through your HSA.  

So if an emergency happens, just submit as many receipts as you need to cover the emergency and you will get a check for that amount.  You can use that money for any purpose and without any taxes or penalties.  

Those little receipts collected over the years can translate into thousands of dollars (or more) of quick, tax-free money any time you need it.  

Pretty cool way to use your HSA if you ask me.

Now bear in mind that you can continue to invest in your HSA and have it grow tax-free year after year.  This strategy does not impact that, nor does it diminish any of the other benefits that an HSA offers.  

But if you ever need cash in a hurry it’s nice to know that you can draw on your HSA funds to get it without much fuss.

Bonus Strategy: Use Credit Card Rewards as an Emergency Fund

This is a strategy that I ran across online.  The basic idea is this:  You accumulate rewards points in your credit cards, but don’t use them.  When an emergency strikes, you can use the points to cover your expenses. 

I think cash rewards where they pay you out would probably work best, although if you can get statement credits, that’s not bad.  

If you can get paid out, I would take it out as soon as possible.  I would then invest it in a Roth IRA so it can actually earn something and not just sit in your credit card account (assuming you make enough qualifying income that would allow you to contribute to the Roth). 

Of course, there are a lot more details to the strategy, but if you want to learn more, check out a couple of articles that I found on the topic.  They are here and here.

Conclusion

Having an emergency fund is critical to preserving your financial stability.  So if you need one anyway, you might as well maximize every advantage available to you when setting it up.  The Roth IRA is a terrific alternative that is available to most working folks.  

And if you are among the lucky workers that can access an HSA, you should definitely look into taking advantage of that account for its many powerful benefits (including, of course, serving as an emergency fund).

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