Where to stash your emergency cash

By Walter Updegrave, senior editor

(Money Magazine) -- Question: I'm 37 years old and currently have about $175,000 in my retirement accounts, including $15,000 in my Roth. I also have a taxable brokerage account with about $15,000 in savings as my safety net, to which I contribute about $400 a month.

I'm confident I'm on target in my retirement accounts, but hate that my cash is just sitting there in my brokerage account. I'd like a relatively conservative investment that will allow me to keep my cash liquid in case I need it. Any suggestions? -- Leo, Oakland, Calif.

Answer: Before I get to suggestions, I want to first point out that interest payments are only one aspect of the return you earn on the money you set aside as an emergency reserve or a safety net. There are several other facets that are just as important, including security, flexibility and peace of mind.

But don't just take my word for it. Check out the shareholder letter that Warren Buffett, aka the Oracle of Omaha, delivered to investors in his Berkshire Hathaway company earlier this year.

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

On pages four and five of that letter, the Buffettmeister noted that when the financial system went into cardiac arrest in 2008 and incapacitated many large financial firms, he was still able to run his business because he maintains a very substantial safety reserve.

"The $20 billion-plus of cash equivalent assets that we customarily hold is earning a pittance at present," he wrote. "But we sleep well."

I think that people too often forget about this reason for having a safety net -- a buffer against uncertainty and the sense of security that comes with it -- and instead worry too much about boosting the return on their cash reserves. The result is that investors often wade into waters teeming with risks that may not be apparent at the time but nonetheless can do them in.

That's exactly what happened a few years ago when people bought seemingly secure investments like auction-rate securities and bank-loan funds for their relatively lofty yields only to get burned when those securities ran into problems.

That said, there are a number of ways you may be able to earn a few extra bucks on your emergency stash without endangering it. The question, though, is how much work do you want to do for a little extra yield and how far do you want to push the envelope on the risk front?

With very little effort and virtually no risk, you can check out sites like Bankrate.com, Bankaholic and Billshrink.com and, once there, compare what you're currently earning in your brokerage account to what's available in cash equivalents like savings, checking accounts and money-market accounts.

By doing this, you'll immediately get the sense of what the most secure accounts are paying -- which isn't much these days, with bank money-market accounts yielding under 0.8% recently. And with just a few clicks you'll quickly find that many institutions are willing to pay a half a percentage point or more above those averages.

Granted, you may have to meet a minimum balance requirement of $10,000 or more to get the juiciest yields. But since you're dealing with FDIC-insured institutions, you don't have to worry about the safety of your principal (assuming you don't exceed the insurance limits.

You can shop at these sites for the best rates on CDs as well, although in the case of CDs you also have another option for boosting yield: going to a longer maturity. The danger is that if you opt for, say, a five-year CD (current average: 2.82%) instead of a one-year CD (1.39% average) and interest rates rise soon afterwards, you could find yourself sitting in a long-term CD with a rate below what new CDs are paying.

You can cash out and jump to a new CD, but you'll likely incur an early withdrawal penalty. That penalty is typically a half year's interest for CDs maturing in longer than one year, although the hit can be much more severe and even result in loss of principal in some cases.

It's possible you could still come out ahead by going with a long-term CD instead of a short-term one even after paying the withdrawal penalty. But that would depend on the difference in yields between the long- and short-term CDs when you buy, how much interest rates rise afterward, how long you've been in the long-term CD and the size of the early withdrawal penalty.

I think playing the maturity game with CD maturities gets into "Is it worth the effort?" territory. For the money I see as an emergency reserve, I'd be more inclined to stick to CDs with maturities of one-year or less, and shop for the best rate in that maturity range. But that's clearly an individual judgment call.

You might also check out some of the high-yield reward checking accounts offered by many banks and credit unions. These accounts have recently touted yields upwards of 6%, according to a recent Bankrate.com survey, which is pretty attractive when most checking and savings accounts are paying well below 1%.

You should know that to get those superior yields, you've typically got to jump through a series of hoops, such as making a certain number of debit card purchases each month, paying bills online and having your paycheck deposited directly.

There may also be a cap on how much you can place in such an account, or at least the amount that will earn the blimpish yield. If you think you can manage your financial affairs while meeting the terms and obligations of such accounts, fine. You may be able to significantly boost your payout on at least a portion of your emergency savings. Be aware, though, that if you fall short of the requirements, your return can plummet.

So before you sign up, be sure you're aware of all the conditions and fees. There are always alternatives out there that beckon yield-hungry savers with lofty payouts. But rest assured, there's always a drawback, whether it's the threat of principal loss in a short-term bond fund should interest rates rise, the possibility of losing dough in high-yield "revertible notes" due to a setback in stock prices or some other pitfall, apparent or not.

So the bottom line is that you don't want to let the desire for a higher yield to compromise the security and liquidity of your emergency stash. To me, this means sticking primarily to readily accessible deposits in FDIC-insured institutions such as savings accounts, money-market accounts and short-term CDs or high-quality money-market funds, even if the return for now is much lower than you would like. After all, if you may not be able to get to your money when you really need it or if there could be less there than you counted on, you don't really have a safety net, do you?

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