Cash for Emergency Savings Fund: Should You Consider Tax Efficiency?


If you have a sizable taxable account, it is possible to place cash needs, such as an emergency fund or home down payment, in a tax-advantaged account and therefore improve the overall tax efficiency.

Please note:  This is a somewhat advanced savings/investment strategy, and you should not pursue it unless you understand the positives AND negatives involved.

How it works

Let’s assume that you have $60,000 in your 401k and $40,000 additional savings outside your 401k.  Let's also assume that you have determined that you need an emergency fund of $15,000.  Depending upon your age, your portfolio may look something like the following:

Taxable
$40,000 tax-efficient stock index funds


Tax-advantaged account, such as a 401k, 403b or IRA
$15,000 money market fund (emergency fund)
$40,000 bond fund

$20,000 stock funds

Now, let's say that you have an automobile accident and and need to access $5,000 of your emergency fund for medical and auto insurance deductibles.

You would do the following:


·         Sell $5,000 from the stock index funds in your taxable account.
·         Exchange $5,000 in the money market fund for similar stock funds in the money market fund in your tax-advantaged account.

The resulting balance in your accounts would be as follows:

Taxable

$35,000 tax-efficient stock index funds


Tax-advantaged account, such as a 401k, 403b or IRA
$10,000 money market fund
$40,000 bond fund

$25,000 stock funds

Notice that you have not changed the asset allocation at all for the non-emergency portion of your portfolio; you still have $60,000 in stock funds and $40,000 in bond funds.   As you begin building up your money market (emergency fund) again in your tax advantaged account, you would need to exchange out of the tax advantaged stock fund, into the money market fund while purchasing new stock efficient stock index funds in your taxable account.

Why tax efficiency is important

The tax efficiency of holding your cash needs in a tax-advantaged account comes in two forms.

While you do not need the cash

While you do not need the cash, tax-efficient stock index funds generally yield mostly qualified dividends; most of the return is from capital gains which are not taxed until you sell. Dividends from money market funds are all non-qualified dividends. In addition, you can do tax loss harvesting on the stock funds.

When you need the cash

When you sell a part of the tax-efficient stock index funds, you realize either losses or long-term capital gains. Losses can be deducted on your tax return after offsetting capital gains, if any. Currently, long-term capital gains are taxed more favorably than non-qualified dividends.

Candidates for tax-efficient stock index funds

Index funds are generally considered to be the best candidates for tax-efficiency. 
Vanguard's Total Stock Market Index Fund is a good candidate in my opinion, but there are other index funds that may better fit your overall asset allocation.

Important points to remember:

Use “specific identification of shares” rather than the average cost for the cost basis of your stocks. Sell tax lots with losses or tax lots with the highest cost basis that have long-term capital gains. If you don’t do this, it's difficult to minimize tax.
  • Avoid a wash sale.  If you sell shares of the tax-efficient stock index funds at a loss and buy "substantially identical" securities in your the tax-advantaged account (within 30 days before or after the sale), that is called a wash sale and losses cannot be deducted.  Therefore, you need to find a fund to purchase which is not "substantially identical" for your tax-advantaged account.  However, it should be similar, such as an active fund in the same asset class as the index.
  • Make sure your taxable account is large enough. If not, then you may not have enough money in your taxable account during a market downturn. Keep in mind that it is possible for the stock market to go down by 50%.
  • Make sure you have shares that you can sell with long-term capital gains. Otherwise, you may have to sell shares with short-term capital gains.  If you are just starting a taxable account, you may want to wait for 12 months before you place cash needs in a tax-advantaged account.