Before you jump to an answer or nasty comment, please give me a chance to elaborate. 🙂 Recently, I ran across an interesting article in the Bogleheads Wiki titled Placing Cash Needs in a Tax-Advantaged Account. Essentially, because of the way the U.S. tax code works it can often be better to keep certain asset classes like cash inside tax-advantaged accounts like IRAs and 401ks. Therefore, if your emergency fund is cash, why not put it inside as well?
I’ll use the example given. Let’s say you have a 401(k) with a balance of $10k and also taxable assets of $10k, for $20,000 total. You choose to have $10k in stocks, $5k in bonds, and $5k in cash for your emergency account. The “traditional” placement for an emergency fund is in your regular taxable account, perhaps in a bank savings account. The rest of the assets are distributed according to this tax-efficient placement chart.
However, in this scenario all your interest earned on your cash will be taxed at your marginal ordinary income tax rate, which can be as high as 35%. See table of 2009 Marginal Tax Rate Brackets. Meanwhile, your stocks will mostly give off dividends, which are taxed at a current maximum rate of 15%, and possibly quite less. So why not put the cash into the 401k?
Emergency!
You may wonder what happens if you do need access to that $5,000. You would simply sell $5,000 of the stocks in your taxable account, and simultaneously buy $5,000 of stocks in your 401k plan. This way, your final asset allocation will look exactly the same as if you just spent your cash from the traditional setup:
If you happen to sell your stocks at a loss, then you may be able to deduct a loss if you avoid a wash sale. You can do this by not purchasing a “substantially identical” security within 30 days, but you can buy something very similar. For example, you might buy the S&P 500 ETF (IVV) and sell the Russell 1000 ETF (IWB). They are very strongly correlated, as shown in this chart. This may or may not be worth the hassle depending on how big a loss you’re looking at.
If you happen to sell your stocks at a long-term gain, then you’ll again only paid long-term capital gains taxes of at most 15%. If you sell at a short-term gain (held less than a year), then you’ll have to pay ordinary taxes on the gain. So it might be good to wait a year to institute this new setup.
The Catch
So there you have it, there is an argument for some people to put their emergency funds into their 401ks! However, for most people I don’t think this idea is very practical. For one, most people have relatively small emergency funds, so the difference in taxation scenarios won’t be very high. This is especially true in the current low-interest rate environment. The highest potential tax savings would go to those with large 401k balances and high income tax brackets.
Finally, besides a few stable value funds that I’ve seen, the yields on money market funds found inside retirement plans are rarely the best available. I can usually find much higher interest rates outside my 401k, usually by at least 2% APY or more.
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Interesting food for thought.
Your last point is important though. It is far easier to chase better interest rates outside tax advantaged accounts. (I know from experience!). I keep a chunk of my efund in a ROTH, personally.
Another point on the taxes though – you would also have gains or losses on sale of stocks. In the end, do you save that much? Losses might be advantageous; not gains. Still worth the work for high worth individuals.
For me? My income tax bracket is low. I think I will stick with my ROTHs and taxable CDs.
I’ve got to be honest…I don’t like this plan for anyone. Your return on cash is always going to be the lowest, returns on bonds in the middle, and returns on stocks the highest (on average, naturally).
With this plan, you’re keeping inaccessible cash in a tax advantaged account…why? It’ll be earning, what, 0.5%? 3% tops when the economy and markets stabilize? Put it in government bonds of some sort. Your returns and investment are as close to guaranteed as humanly possible in a free market.
With keeping your emergency fund in stocks, you also risk losing it to market fluctuations. Say your proposed setup above had been established in 2007? Your emergency fund would have been cut down to $5,000 even before the hypothetical emergency. And those realized losses can only offset realized gains…but what gains? In this market? Carryforward to future years?…That’s not much use to my clients when cash is tight right now.
And the Feds are going to let the tax rates on cap gains and divs reset to higher levels (20% and marginal, respectively), so this really doesn’t work beyond 12/31/2009.
That $5,000 in the 401k is largely inaccessible regardless of its allocation and should not be considered when developing a family’s emergency fund. This idea is letting the allocation tail wag the financial planning dog. Interesting conversation starter though…
I like the alternative thought approach but it doesn’t make much sense. Even if you are in the 35% marginal tax bracket (call it 30% effective just for math purposes…probably high), and you have a $50K emergency fund.
$50K * 2% (interest rate you are getting on cash) = $1,000 *30% = $300 Tax.
For 300 bucks or 25 bucks a month do you think jumping through these kind of unsure risks are worth it? You have wash rules, transaction costs, loss of investments PLUS the fees associated with a 401(k) will probably eat into the whopping 25 bucks a month anyway.
I view my Roth IRA as something I can use as a last resort emergency fund. I have approximately 3-4 months living expenses in my savings account. My worst case scenario that I can imagine at the moment is losing my job, but that 3-4 months could be stretched out longer with the aid of unemployment. I can’t foresee any reason to tap the additional money I have tucked away in my Roth, but it’s good for peace of mind to know that if I absolutely had to I do have extra money I can access with very little hassle. Ideally, I want to leave it untouched until retirement.
As an investor, I don’t like this plan either. 3 or more years ago, I would have thought that this would be a stupid post. Any minimal yields by cash funds are offset by the high costs of retirement account fees.
But truth be told, in the past couple of years, I have done this. I have recently set up cash in my retirement account.
The worst case scenario is what if “my regular accounts and emergency cash” are exhausted? That would only leave the assets in my retirement accounts. If I were to tap in on that, I would want some funds to be stable and not losing value within a declining market. And as you suggested, avoiding wash sales helps. Of course, I would not want this to ever happen, but what if?
When framing things this way, this actually is a sane idea. The alternative to cash would be short-term bond funds. The question is, have you done something similar…money markets in your retirement funds?
Zach makes a good point: if you lose $5,000 from your taxable account in a bear market and then have a $10,000 emergency, you’re going to have to liquidate part of your 401(k), paying not just the taxes you were trying to avoid paying, but also a penalty.
Doing this inside a Roth IRA (assuming the person is eligible) rather than a 401(k) would make more sense because the contributions to the Roth can be withdrawn without a penalty.
Some good points from both Mr. Money Blogger and Zack. But I have to say I agree with Zack. Your gains will be much higher with stock (in general) than cash, so naturally I think you want your stocks in the tax advantaged accounts, even if the tax rate is higher on cash sitting outside vs. inside.
Basically, if you look at $ gained from stock vs. cash and the tax implications, I would assume you save more tax with stock inside the tax advantaged than cash inside.
But I think the stock fluctuations are irrelevant, because you are simultaneously selling and purchasing.
I personally think that an emergency fund should be liquid so I wouldn’t use this strategy. On the other hand I have a similar strategy for saving for a down payment on a house.
First, I set my goal for how much as a percentage of my salary I wanted to be saving towards retirement, both in a Roth IRA and my work 401K. This is really important, avoid sacrificing retirement goals to buy a house.
Second, I contributed the max to the Roth IRA and the max I was comfortable with to the 401K. The goal here is to shelter as much income as possible from taxes, while having adequate cash flow to live.
Third, divide the money going into the retirement accounts into money for retirement and money towards the down payment. Retirement money has the same asset allocation I decided on before this strategy, down payment money is liquid, its in a mix of TIPS, short term bonds and money market funds.
Fourth, when house buying time comes along I can withdrawal the liquid portion from my Roth IRA and take a loan against my 401K.
Fifth, I’ll cut my retirement contributions back to just get my employer match. I’ll also gradually shift the money (DCA) from the down payment part of my retirement fund into the more equity heavy retirement pot, so that I am still reaching my retirement goals.
It doesn’t look like this will work unless you have significantly more stock assets in your taxable account than you have emergency fund cash (as they do in the example above).
To illustrate, consider a simple scenario of $5,000 cash in your 401K, and $5,000 stocks in a taxable account. If you need access to the cash, you sell your taxable stock, and buy stock in your 401K, your asset allocation has not changed, and all is well and good. But what if the market drops 50% (as recently seen)? Now you have $5,000 cash, but only $2,500 stocks. You can extract only $2,500 worth of cash, leaving $2,500 stock and $2,500 cash in the 401K. How do you extract the other $2,500 cash in an emergency (like, say in a recession following the above market crash)?
You would have to keep double the amount of your emergency fund cash in taxable stocks in order to weather a 50% market downturn (or more, if you expect stocks to decrease by more than 50%). Do you still gain the tax benefits if you have to keep more assets in taxable accounts? All in all, sounds a bit risky to play with “emergency” cash, especially for limited gains. If you already have a large taxable brokerage account (i.e. at least equal to your emergency fund) this could probably work, but at that point your emergency fund is likely a small part of your total portfolio, so I doubt it makes sense even then.
If you are financially savvy enough to be worried about tax consequences, you likely will be trying to build an emergency fund *in addition* to retirement savings.
Emergency fund in a retirement account is a great idea for someone who is cash strapped and would not fund their retirement account otherwise. If they don’t run into an emergency in a few years, they have the contributuions in a retirement account that they would never be able to add back. In addition if the money goes into a 401(k) you may get a “company match” which you would not get in a taxable emergency fund.
In a 401(k) you are probably pretty limited in what you can put the money in, but in an IRA one should be able to buy the same type of products that one could outside of the account (CDs, Money Market, etc).
But the ultimate goal is to fully fund retirement accounts and have an emergency fund on top of it.
If after emergency you do sell at a gain, wouldn’t you actually qualify for a wash sale if you bought the same stock in your tax-advantaged account?
The problem I see is that what you actually pull emergency funds from are stocks, not cash. Similar to Zack’s scenario, you could end up with a smaller taxable stock portfolio than available cash in the 401(k) due to market crashes. It would suck to have to liquidate positions after a market crash due to an emergency when that would be the time to start buying more stocks and not selling. This opens the door to buying high then selling low if conditions are right and with the layoffs that come with a recession, it’s a very likely scenario:
Market tanks, your company lays you off, now you’re selling beaten down stocks to cover you during the length of your unemployment.
I don’t think a tax deduction for your loss will comfort you during such an emergency. It would be better to just have the cash instead. Things could work out differently but when it comes to the emergency fund you should plan for the worse situation possible to make sure you’re covered when needed.
Saving in USD is a waste … The currency will be almost worthless as we rack up 7T in debt and keep printing money.
The best thing – do what the host did and but a house with as little down as possible. 800-1.2m in bay area. Spend your money NOW on tangible and non-tangible items. Enjoy today. Tomorrow the USD will be worthless as the govt will not be paying back the debt. CA is a good example of what happens with over regulation and taxation.
Anyway spend now buy an expensive house and when the dollar totally collapses enjoy the fact your mortgage is still the same. What today seems like a big mortgage will suddenly be pennies on the dollar!
I love the way you are thinking outside the box. What is the number one goal of an emergency fund? Is your method perfect for that goal? If the goal is liquidity I would have to say no. The transaction costs and time delays with stocks or ETF or whatever you are trading need to be accounted for. Also watch out for the 401k. Fees might destroy the small cash returns. Alot of cash or money market accounts have weird rules about moving in and out of the fund as well as market value adjustments.
Now a Roth IRA could be used as a secondary emergency fund. Where you can pull out contributions without penalty. It is important to keep tabs on transaction costs and time in this case though.
PS – @akb your comment is a blog post in and of itself. You scare me!
When you talk about emergency funds, how quickly will you need access to the funds? Taking out a 401k loan can take time, or at least several days, while true emergencies may require same or next day liquidity.
If dividends are taxed at 15%, and cash would be taxed at normal rates, with the normal federal deductions the tax rates on the cash would be less than 25-28%. Complexities of the suggested system aside, you would just need to run the math on the taxes that would be paid.
Let’s say the dividend rate on your stocks is 3%, and the rate on cash is 1.5% with a tax rate of 25%. On a 10,000 balance, after taxes the dividends would earn $255, and the cash would earn $112.50. Does that outweigh the extra work involved? You would need to run the math on your own (and choose whether or not to assume any capital appreciation in the stocks).
I like the article, as it is certainly thought provoking and not the normal mode of thinking. Definitely an article to link to.
If you have to use graphs and more than 500 words it is too complicated, besides saving for retirement needs momentum behind it, if you potentially pull money out of it the momentum is lost. It is kind of like starting and stopping during a race, you lose energy if you are starting and stopping all the time.
I decided to write a post in response to this. It seems to me that the main thing to do would be to calculate if the interest savings would be worth the extra complexity: http://bit.ly/yLJHq
Do people read the full post before commenting? Man there are some really *blip* comments here… read carefully what is being stated and THINK about it….
I am not saying this is a great strategy that fits all needs, but some comments just have nothing but air… momentum? wtf? either way you will be saving for retirement and for an emergency. The only thing that changes is your asset allocation!
lack of available cash investments? off course, the original post points it out…
2% interest rate? sure it is not going to make much of a difference, what about when inflation kicks in a interest rate go to 5%, 7% or 10%… does 1k, 2k, or 3k sound like chump change?
Oh boy, maybe I am just a bit annoyed today 😉
@hey Imtoast. Retirement is never to be touched, don’t mix goals in one account because the emregency fund will always trump retirement. Why over complicat your life. Do you get that? If my post got you annoyed man you need a life because you certaintly don’t have one.
P.S. You were right I did not read the article because he needed charts and a ton of words to try to convince people.
I wouldn’t mix 401K with emergency fund, but I do have a certain portion of my 401K in stable value. This is not for emergencies, I simply consider cash (or stable value) a valid portion of my asset allocation. I don’t understand, by the way, why when people talk about diversification, people only talk about stocks and bonds. Cash is an asset class too, so are commodities if your 401K has a commodity fund.
BTW – the annualized return on my 401K’s stable value over the past 20 years easily beat stocks. Keep in mind that when interest rates go up so will the percentage paid on stable value. Also keep in mind when you look at bond fund yields that since 1980s we had falling interest rates environment. This is the environment when the bonds’ value goes up. Do you think this is going to be repeated?
Not only that, people seem to routinely use individual bonds and bond funds interchangeably. These are different. Bond funds don’t come with an option of waiting to maturity, so they can lose value, which is why I only buy bond funds when there is a reason to believe for bond funds to increase in value or the yields are attractive: e.g. last fall when the panic created attractive yields or in the 80s when the interest rates were high and falling. So while I have some inflation-protected bonds in my 401K as well as a couple of corporate bond funds that I bought last fall, I plan to move money out of corporate bond funds as soon as the probability of interest rates going up is higher.
In taxable accounts I also have cash, CDs, a small amount of individual bonds – I bonds, some municipal bonds and corporate, and stocks. In taxable accounts I am more heavily invested in stocks than in 401K because of lower tax rates. I think right now – and I moved a bit of money out of stock funds in 401K last week just to preserve some recent gains – I only have about 40% of retirement money in stocks (including a small commodity fund), whereas my taxable accounts are about 60% stocks.
@Hogan: you need to go back to school and pick up some reading skills… I would suggest maybe 3rd grade? where do I state that YOUR post got me annoyed?
Furthermore, if mental accounting or any post with charts is too challenging for your, then by all means don’t try what was suggested here or anything more complicated than ordering fries and shake at your local fast food place…
As for your statement that “Retirement is never to be touched.” Please read the post and THINK before posting again. No one has suggested that here! I know its painful, but start using your brain and do some research about asset allocation and basic accounting (mental more than anything.) Maybe that way you can post something that makes sense….
Remember that just 2-3 years ago, savings accounts and money market funds were paying more than 5% interest. By the end of 2007, I had 6 figures in savings — 5% interest taxed at 25% Fed & 10% state would be $1750 in taxes. I definitely would have used this technique but unfortunately, my 401K & IRA balance was nowhere big enough to pull this trick off.
Sure it’s more complicated — guess what, life is complicated. Tax rules, government rules, credit rules, work rules — all extremely complicated but free cash can be there for the taking if you can game the rules (e.g. balance transfer, tax loopholes, pension spiking). Those who don’t want to do the work in picking up extra cash, that’s your own choice.
And no, there is no need to take out 401K loans to make this scheme work. You simply sell your taxable stocks for cash — that money is there immediately. (Ok, could be 3 days if you have a cash brokerage account — 1 day for mutual funds.) Then login to your 401K account to sell bonds/money market to rebuy the same taxable stock. If your plan is directly with a big player (Fidelity, T.Rowe Price, etc), the asset reallocation happens next day. With a TPA that runs its own platform, 2-3 days max for the transaction to happen.
>> P.S. You were right I did not read the article because he needed charts
>> and a ton of words to try to convince people.
Heaven forbid!!! A *ton* of words! Sheesh….
Anyway, I think this is a great strategy and I plan to implement it in the next year or two..and maybe with only 2/3 of my emergency fund.
And to those who talked about retirement account fees and transaction fees – check out http://vanguard.com .
Frank
To reply to this quote and similar comments:
“Emergency fund in a retirement account is a great idea “only” for someone who is cash strapped and would not fund their retirement account otherwise”
Not entirely true. If you are married, are offered 401(k)s (each spouse) and are eligible for ROTHs, you can contribute $43k into tax-advantaged retirement funds in the year 2009. How many young people would actually put away $43k in one year?
I personally keep some emergency savings in my ROTHs, so that I can justify putting more into retirement accounts, than I could otherwise. I wouldn’t exactly consider myself “cash strapped.” Retirement contribution to max out is 25% of income, for us. I know many who can max out up to much larger percentages (e.g. $43k on $100k income?)
Even well off and financially savvy people have to balance how much they are willing to tie up in retirement funds, for the tax advantage.
Obviously, this post had nothing to do with touching retirement money. But it does have to do with a willingness to think outside the box.
Very interesting idea – one big concern comes to mind, and you must understand that I may be coming at this from a different angle than most, as I make my living from trading my own funds.
1 – you call it an emergency fund, but in essence, it is still retirement dollars that you are using. Which means that you are missing out on the tax-free compounding possibilities for those dollars when you have them parked in cash within the 401k/ira.
I think it’s probably fine to keep some funds designated for emergencies in a 401(k) or Roth IRA, as long as some funds are kept in a liquid savings account (taxable). Suppose you keep $1,000 in a savings account, and the rest in your 401(k). If it’s reasonable to assume that most emergencies will be small (unexpected car repair, for example) and under $1,000 apiece, then as long as this $1,000 fund is replenished after each small emergency, the person will only need to tap their 401(k) for large emergencies exceeding $1,000 in cost.