How best to save for my rainy-day fund

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Don Taylor

Don Taylor

Dear Dr. Don,
I am trying to build my cash reserves in case of another layoff. I have decided to put two months' expenses as a buffer in a money market yielding less than 1 percent. To meet the six months' of expenses minimum often recommended, I want to sock away at least four more months' worth, but I don't want it all to sit in a low-yield money market. I found a certificate of deposit that will give me a 1 percent yield over a 12-month term.

I was thinking I would open six CDs with one-year maturities each covering about one month of living expenses plus an additional cushion. If I don't need the CDs' funds when they mature, I think I'd roll them over and invest any excess cash in my variable universal life policy or perhaps my Roth 401(k). Is this the best way to manage my emergency funds? Or should I place the $12,000 in a money market fund and invest the rest?

Thank you,
-- Justin Time

Dear Justin,
This really is a classic dilemma. In an ideal world, you won't need to tap your emergency fund, so why have it sitting in a low-yielding money market mutual fund or money market account? You've learned from experience the value of having such funds in the event of a layoff, so you understand the need for easy-to-reach reserves.

By shopping for the best national rates, you can earn the same rate in a high-yield savings account as in a one-year CD. That negates the need for a laddered CD portfolio for your reserves. Also, don't forget to look at the yields offered by your local credit union. Bankrate's money market account rate and CD yield comparison tools can help with that research.

You could also take a so-called barbell approach investing in your emergency fund. By that, I mean that you'd keep half invested short-term in a high-yield savings account, and the other half invested in a five-year CD. You'd pay an early withdrawal fee if you had to tap the CD. But, if you don't pull out the money, you'll earn five-year rates on the investment while keeping three months' of living expenses in liquid funds. You can currently earn over 2 percent on a five-year CD, doubling the yield on half of your fund.

I don't know anything about the insurance policy you mentioned, so I can't comment on the advisability of adding to it. If your company matches all or part of your Roth 401(k) contributions and if you aren't contributing up to the limit of that match, I'd support additional Roth 401(k) contributions. Remember, taking the company match isn't tax-free in retirement.

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