Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Emergency fund yields

Dear Dr. Don,
I currently have $16,450 (three times my monthly take-home pay) in my savings account as a reserve fund in case of emergency (i.e. loss of job, extended illness, etc.). It is earning a paltry 0.6 percent interest. Obviously I would like for this money to work a little harder. What options are available to me that would provide me with a decent return, yet not be so restrictive that if I should need to access this reserve, I don't end up paying large penalties?
Martin A. Mass

Dear Martin,
It's a classic conflict inherent to investing an emergency fund. You want the money to be readily accessible, but hate earning money market rates on an investment you hope to never need to cash in.

There are several potential solutions, but you need to keep in mind that by searching for yield (return), you're taking on some measure of risk. I'll discuss two alternatives.

Certificates of deposit are an easy choice. With an FDIC-insured deposit, you're not facing any risk to principal; you just have to be willing to pay any early withdrawal penalties if you redeem the CD prior to its stated maturity. Make sure you understand the terms of the deposit, including early redemption penalties, before investing your emergency fund in CDs.

The idea behind this approach is that the increase in yield compensates you for the risk of paying an early withdrawal penalty. Giving back three months' worth of interest earnings is OK if you've earned five times the yield over what your savings account pays in interest.

Using Bankrate's Highest Yield feature for CDs, I found six firms today offering a 2.5-year CD yielding over 3 percent annual percentage yield. With the low rates in the current interest rate environment I'd be reluctant to recommend five-year CDs yielding over 4 percent, but you could consider building a laddered CD portfolio that had monies invested in different maturities. Bankrate's "How to Ladder CDs" discusses how to build a laddered CD portfolio. Our calculator helps you learn how to maximize returns with CDs.

Banks also offer "liquid CDs" that allow some penalty-free withdrawals from the account but pay a lower interest rate than the same-term CD that isn't penalty free.

U.S. savings bonds used to be an easy choice, but now, along with three-month interest penalties for early redemption in the first five years of ownership, the government requires a minimum holding period of one year.

If you've got some measure of flexibility in your investments, however, you can invest in savings bonds and, as they pass the one-year mark, count them toward your emergency fund savings. Allocating these 1-year-old savings bonds to your emergency fund allows you to move money from your savings account into longer term investments. This approach takes some time to put into effect but, with Series EE bonds currently yielding 2.61 percent and Series I bonds yielding an inflation-protected 2.19 percent, you'll be on your way toward improving the yield in your emergency fund. (Yields change every May and November.)

You can defer until redemption or maturity the federal income tax due on savings bond earnings. The earnings are also exempt from state and local income taxes. The Savings Bonds for Education program also may provide you with the ability to buy bonds for an emergency fund in your name and use them later to fund education expenses. Use the savings bonds to fund qualified education expenses and the interest income is free of federal income taxes. There are income restrictions on who can use this program.

The Savings Bonds Owners Manual is available online and provides all the background you need to decide if it makes sense for you to move your emergency fund to savings bonds over time.

-- Posted: March 4, 2004