Your Emergency Fund Doesn't Belong in the Stock Market -- Here's Why

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Building an emergency fund is a cornerstone of personal finance -- and once you've got that money saved, it's crucial to find the best place to keep it (and no, keeping it in your checking account isn't usually your best move).

If you invest it, you stand to grow it much more than if you kept it in an FDIC-insured bank account -- the stock market has returned an average of about 10% annually over the last 50 years. But your emergency fund is specifically for expenses that aren't anticipated, and risking it is a terrible idea.

Let's examine why investing your emergency fund could be a losing proposition -- and where you should keep that cash instead.

Your emergency fund could drop in value

Stock investing isn't without risk. There are ways to mitigate that risk; namely, it's best to invest for the long term (at least five years) and to select investments that have a proven track record of success (like index funds tracking the performance of the S&P 500). But the fact remains that keeping your emergency fund in the stock market means opening yourself up to loss.

Say you've got an emergency fund that covers six months of your regular expenses, totaling $30,000. And you've decided to put that cash in a brokerage account and use it to buy stocks. But then you get laid off, and your job loss coincides with a market crash that brings the value of your investments down to $24,000.

Now you're without a source of income, and you've got to sell your stocks and lock in those losses, because you need the money to cover the bills while you look for a new job.

Oh, and your emergency fund will no longer cover six months, so the clock is ticking on your job hunt. This isn't ideal -- and it's a prime example of why your emergency fund doesn't belong in the stock market.

You'll pay taxes when you sell investments

If you need money for an unplanned expense, having to pay taxes to access it is another problem with investing it. Depending on how long you've held the investments in question and if you've made any gains on them, you could owe a fair bit in taxes.

Investments you've had for less than a year are subject to short-term capital gains taxes, which are equal to your usual top income tax bracket. If it's been more than a year and a day, you'll pay long-term capital gains taxes, which range from 0% to 20%, depending on your income -- this is the preferable option.

But since an emergency can happen anytime, it's smart to keep your emergency fund in an account that won't tax you to take money out (more on that below).

Where does your emergency fund belong?

If you've read down this far, you know where not to put your emergency fund. So what kind of account is best for this crucial cash? You have a few options.

A high-yield savings account is likely the easiest place to keep your emergency fund. The best ones are offered by online banks, and by "best," I mean they won't charge you silly fees or pay a criminally low APY on your money.

HYSAs paying APYs around 4.00% are still pretty common, but with the Federal Reserve likely set to start lowering the federal funds rate this month, you can expect rates to decline over time. Even so, a HYSA with an online bank is likely to keep paying better than a big-bank savings account, many of which pay just 0.01%.

Another good option is a money market account -- these pay around the same APYs as HYSAs if you open one at an online bank. And unlike a HYSA, you'll get one-step money access. Money market accounts often come with debit cards or check-writing privileges, so if an unplanned expense pops up, you can whip out that debit card or checkbook to pay for the problem.

Whichever you choose, dig into reviews from professionals (like us here at The Ascent) as well as regular people. See what APY you can expect to earn on your money (because even your emergency fund shouldn't lose buying power thanks to inflation), how to access it, and what fees you might be charged. This way, you can land on the right home for your emergency fund where your money won't be at risk.

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