by Archie M. Richards, Jr., CFP^®
May 16, 2005

Lee wrote, "I have 6 months of emergency living expenses ($20,000) invested in CDs. I'd like to start buying I-bonds. What do you think about this? Also, should emergency money be held in a taxable account or a retirement account?"

For a year after you purchase I-Bonds, Lee, you can't sell them. What good is this for emergencies?

If you sell within five years, the three most recent months of interest are forfeited.

Money held for emergencies often must be spent soon thereafter, preferably without incurring extra costs. I-Bonds don't suit this purpose.

Using a retirement account incurs similar difficulties. With most retirement plans, withdrawals are subject to ordinary income tax and possibly penalty taxes as well. With some plans, it's difficult to get the money out at all.

No, hold your emergency money in a taxable account to which you can gain access on short notice.

Which leads to a related issue: Is six months of income the right amount to hold in reserve for emergencies?

If a full $20,000 for emergencies makes you feel comfortable, Lee, who am I to argue? But I believe two months of income should be enough. Put the rest of your money to work, mostly in stocks. If a big emergency requires more than two months of income, pay whatever's necessary with credit cards. Then sell some of your investments and repay the credit cards. Emergencies, remember, are unlikely.

Okay, now let's get to I-Bonds. They're U.S. savings bonds whose interest has two parts.

• One is a relative low rate that remains unchanged for the bond's duration. The current rate on this portion is 1.2 percent.

• The other portion is adjusted each year on May 1 and November 1 according to the government's measure of inflation. The current rate on this portion is 3.6 percent, making the total interest rate on I-Bonds 4.8 percent. (I-Bonds are well explained in www.treasurydirect.gov.)

I must say, 4.8 percent interest isn't bad, especially since I-Bond interest is exempt from state taxation (like all Treasury debt). But, as I've said, you can't withdraw the money for a year.

During the next 12 months, I believe the world's stock markets will rise a lot more than 4.8 percent. I'd rather you put the money into stocks.

In general, avoid investments that protect against things most investors are worried about. Worries that are widely shared usually turn out to be unexpectedly mild. The majority is almost always wrong about future economic trends.

The Federal Reserve is worried about inflation, to be sure, and this is making everyone else worry about it too. But the Fed has the power to do something about inflation, and it is exercising that power by restricting the growth of the money supply.

The Fed will succeed in cutting inflation down to size. Count on it.

In the long run, technological advances will make possible a worldwide flood of goods and services that I believe will bring inflation down to zero and eventually cause deflation. The deflation will be benign. Unlike the 1930s, prices throughout the economy will fall while national income does not.

If inflation disappears, as I expect, the inflation portion of the I-Bond interest will disappear. You'll be left with the unchanged interest portion of only 1.2 percent, plus the return of your principal.

For emergency funds, consider Vanguard's Short-Term Bond Index Fund, which currently pays income of 3.8 percent. If inflation disappears (and interest rates decline), the interest yield on the fund will fall. But the bond prices will rise modestly, causing the fund's principal value to rise as well.

In general, minimize your emergency money. Invest where you can get at it quickly with little cost. This isn't the case with I-Bonds.

Avoid inflation hedges. People are too concerned about inflation. The majority is usually wrong about economic projections.

Look the opposite way. Most people are down on stocks. Now is therefore an especially good time to buy them.