Francis Xavier Bergmeister, CFP
What are you going to do in retirement if you spend down your emergency fund? Three to six months’ worth of living expenses is the target amount agreed upon by most financial planners. The U.S. Census Bureau notes the average age for retirement is age 63 and the length of the average retirement period is eighteen years. But what if you retire sooner and live longer?
An emergency fund portfolio should be invested for liquidity. Savings accounts and money market accounts are attractive investments for this reason. Certificates of Deposits (CDs) can deliver more interest but there is a penalty for cashing out a CD before it matures. Navy Federal Credit Union’s money market currently offers 0.5% as an annual return on its money market account while Bankrate presently is offering 0.7% on a $2,500 CD maturing in two years. Some banking institutions and credit unions also offer no-penalty CDs. Such CDs, however, offer lower interest rates as a feature in their design. Yet another option is dividing the emergency fund among several smaller regular CDs maturing at different intervals. This laddering technique can minimize early withdrawal penalties. Be aware the emergency fund’s annual interest for money markets or CDs is taxable in the year earned.
You probably will consider using the method of present-day living expenses at the time of your funding your emergency account. But what if your emergency happens ten years after your retirement? The bad news is the emergency account in ten years will not have earned enough to have kept pace with inflation. Ask anyone with a recent home repair project that included lumber.
Federal retirees worried about using their emergency fund in ten years or beyond have two choices. Save more money in the emergency fund or draw down on their Thrift Saving Plan (TSP) or other taxable investments earmarked for livening in retirement. Dedicating more dollars in the emergency fund will mean limiting the investments to the less volatile but safe money markets or CDs. Accelerating withdrawals of the TSP or other taxable investments originally intended for normal retirement expectations will mean higher taxable income in the year of the emergency withdrawal. Such a withdrawal of resources to pay for an emergency crisis because an emergency pool of dollars has been exhausted can significantly modify a planned lifestyle. Retirees need to also be vigilant about their taxable income in the year of a financial emergency triggering higher future Medicare Part B premiums if money is taken from taxable accounts.
A Roth TSP account can be a valuable “insurance policy” for Federal employees to make their emergency funds prepared for the decades during their retirement.
Allocating a percentage of their TSP contributions toward a Roth TSP is filling a bucket of tax-free future dollars growing tax-deferred that can be accessed without taxable consequences when needed unexpectedly.
If you have both Traditional and Roth TSP accounts, you can specify that your withdrawal for emergencies in retirement should come only from the Roth account. Here is an example of how this strategy could work. For simplicity assume an employee at retirement has a Traditional 85% / Roth 15% blend of TSP savings. She invests the entirety of her TSP in the L income fund. A separate emergency fund of $15,000 has been set aside in a money market account at a credit union.
If the total TSP savings at the time of retirement were $500,000 this would be $425,000 in the Traditional account and $75,000 in the Roth account. In this scenario, the employee worked in the private sector for ten years after Federal employment. She did not need to draw down on the TSP funds or use the emergency fund during that time.
For the last 10 years the L income fund averaged 4.42% annually. The result was the Traditional account increased to $654,976 and the Roth account expanded to $115,584. Since the individual did not access her emergency fund it grew to $16,569 assuming a compound interest rate of 1.5%. Taxes were paid on the emergency fund interest from sources external to the emergency fund.
Establishing an emergency plan prior to Federal retirement and designating a percentage of the TSP savings to a Roth TSP is an “insurance policy” against future inflation for an emergency that may occur years from now. This is because a Roth TSP apportionment offers on call liquidity to the low yielding income of the emergency fund and the Roth account will continue to grow tax free while invested in the Thrift Savings Plan.
Individuals continuing to work, after Federal service also benefit from the Roth TSP strategy. They can optimize contributions to a tax deductible 401(k) and/or an IRA focused for tax-deferred growth thus reducing taxable income while working the second career. This is possible because the emergency savings account created and funded years ago, although weathered by years of inflation, has benefited from the Roth TSP growth.
Francis Xavier (FX) Bergmeister, CFP®, CLU®, ChFC®, CASL®, ChSNC® is a graduate of the Wharton School. His graduate work includes a Doctor of Arts from George Mason University. He is a retired U.S. Marine Colonel and FBI Analyst. He provides seminars to federal employees and is the owner of Semper Why, LLC.