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Re: FAQ: Choice for Emergency Fund

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By Mark0Young
July 27, 2005

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I concur with the other replies about avoiding stocks for an emergency fund.

A couple days ago I checked current rates for my credit union, for money market accounts, for several Vanguard money market funds, for the top yielding (highest APY) 1-yr and 2-yr CDs as reported on Bankrate.com (GMAC Bank the top listed, so I checked directly at the GMAC Bank web site), I-Bonds, EE-Bonds, 5-year Treasury, 10-year Treasury, normalizing the returns to after taxes. My situation may be somewhat odd because my high 403(b) contributions plus itemized deductions plus capital losses offsetting income at $3,000/yr put me in the 15% federal marginal tax rate but my state marginal tax rate is still at 9%.

For my tax situation, the best after-tax returns were:

1. Current yield on I-Bonds               (4.80% -> 4.08% after taxes)
2. 10-year Treasury Bond                  (4.24% -> 3.60%)
3. 5-year CD at GMAC Bank                 (4.65% -> 3.53%)
4. I-Bonds if inflation were at 3% (approx 4.1%  -> 3.48%)
5. 5-year Treasury Note                   (4.06% -> 3.45%)
6. 4-year CD at GMAC bank                 (4.50% -> 3.42%)
You will notice that the before-tax returns are not strictly in order when I list the returns after tax. That is because bank instruments are taxed at both state and federal levels, but interest on Treasury obligations (including savings bonds) are taxed only at the federal level. Your numbers may come out different between the various instruments if your federal marginal tax rate is higher or lower.

While I don't like the I-Bond (Series I Savings Bond) fixed rate of only 1.10%, it still comes out better than the other instruments and, even if we assume return to 3% inflation, it would still beat everything I looked at except for the 10-year Treasury Bond, and I consider the 10-year Treasury Bond as really a little too risky for emergency savings because of interest rate risk.

The I-Bond has some tradeoffs. First, it is illiquid for the first year of ownership, so one doesn't want to tie up too much money in the period of illiquidity. (My move into Savings Bonds was back when the period of illiquidity was only 6 months and the fixed-rate component of I-bonds were 3% and higher.) But one feature of I-Bonds and EE-Bonds that isn't reflected above is that one can elect to either report the interest on all I-Bonds and EE-Bonds every year, or (paperwork-wise easier) delay the reporting of the interest until redemption, final maturity (30 years from month of issue) or a taxable reissue, whichever occurs first. Another down side of Savings Bonds is that there is a 3-month interest forfeiture if redeemed within 5 years of issue, but after five years there is no longer a penalty for redemption, giving one up to 25 years for continued growth without withdrawal penalty. (With 5-year CDs at GMAC Bank, there is also a 90-day interest penalty for early withdrawal, but, unlike holding on to an I-Bond, at the end of 5 years that CD can roll into a new 5-year CD and again it would be 90-day interest penalty for early redemption on that new CD.)

I am slowly trimming back my credit union money market account because it is paying only 0.70%APY, but I still want some money there for immediate liquidity. But I plan to shift the rest over into I-Bonds if interest rates for other instruments remain about the same.

Now, with the FOMC still raising rates, it is still possible that short-term interest rates (money market accounts, money market funds, 1-year CDs) will continue to nudge upward, and inflation rate as measured by the CPI-U, could change the numbers and make something else the top winner. Unfortunately, we know what instrument is best only in hindsight.


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