Navigating the tax landscape: The tax implications of emergency savings accounts

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Devin Miller
April 2, 2024

In an increasingly complex tax environment, knowing how to effectively navigate the intricacies of emergency savings accounts (ESAs) is crucial for financial planning. With various emergency savings options available, from traditional savings accounts, to money market accounts, and specific tax-advantaged savings structures like those detailed in the SECURE 2.0 Act, it’s important to understand your options and choose one that aligns with your larger financial goals.

Vital for weathering financial storms, emergency savings provide a critical buffer for unexpected expenses and help prevent individuals from dipping into long-term investments or going into debt. From a financial planning perspective, it’s helpful to understand these funds as a way to both safeguard your assets and leverage potential tax benefits. SECURE 2.0 introduces provisions for sidecar or in-plan ESAs—funds that are built into employees’ retirement savings. In contrast, out-of-plan ESAs offer more savings flexibility and wider eligibility​​.

As we delve into the tax landscape of emergency savings, we'll address various considerations around emergency savings structures and the strategic advantages each type offers. Let’s get started.

Tax treatment of traditional savings accounts

Historically, traditional savings accounts have been a cornerstone for many individuals looking to create an emergency fund on their own. These bank accounts typically offer a modest interest rate on deposited funds, with the advantage of high liquidity so account holders can deposit and withdraw funds on their terms. However, the tax implications of the interest generated by traditional savings accounts are often overlooked.

The IRS considers this interest as taxable income, which means it’s reported on your tax returns and taxed according to the U.S. progressive tax system. Accordingly, your income falls into buckets based on your income, and each amount fills up and is taxed (marginal tax rate) before going to the next tax bracket. When you add in standard or itemized deductions and credits, each individual’s amount owed will be unique to their spending and earnings. 

Depending on the income bracket your interest earned falls into, the taxed amount can alter the amount you gain from your savings.

The true value of a traditional savings account lies in the liquidity and security it offers. You can trust that the funds are available when you need them. When it comes to tax strategy, it’s all about striking a balance between the ease of access to your funds and the tax efficiency of your savings strategy.

Tax-advantaged emergency savings options

As the landscape of emergency savings has evolved, more vehicles have emerged that offer tax advantages to individuals looking to save for the unexpected. Among the popular choices are:

  • Health Savings Accounts (HSAs): HSAs provide a triple tax advantage for individuals with high-deductible health plans: contributions are tax-deductible, earnings grow tax-free, and withdrawals for qualified medical expenses are untaxed. 
  • Roth IRAs: While typically used for retirement savings, Roth IRAs permit tax-free withdrawals of contributions at any time, making them a potential source for emergency funds.

Traditional retirement accounts are not ideal for emergency savings, however. They’re designed for long-term savings and may impose penalties for early withdrawals, which could lead to added costs when withdrawing emergency funds. 

The recent introduction of the SECURE 2.0 Act has brought Pension-Linked Emergency Savings Accounts (PLESAs) into the spotlight. Also called sidecar or in-plan ESAs, these accounts are associated with 401(k)s or 403(b)s and offer tax-advantaged savings specifically for emergencies. The IRS has released initial guidance to assist in the implementation of these provisions: 

  • PLESAs are designed to work within the structure of a defined contribution plan
  • They are treated as designated Roth accounts
  • Contributions are subject to a cap—currently $2,500, or a lesser amount determined by the plan sponsor 
  • Eligibility generally excludes highly compensated employees as defined by the IRS
  • If an employer makes matching contributions, those funds are allocated to the retirement account, not the PLESA
  • PLESAs are only available to employees who are eligible for retirement accounts

PLESAs offer an additional option which may be appealing to certain employees as an easy first step in building an emergency fund, despite the limitations.

Penalties and withdrawals tax considerations

When establishing tax-advantaged accounts for emergency funds, it’s important to be aware of potential penalties to avoid unexpected tax implications. Some things to keep in mind include: 

  • 401(k)s and traditional IRAs: Early withdrawals can lead to taxes and penalties, typically 10% for distributions taken before age 59 ½. 
  • Roth IRAs: They allow you to withdraw contributions (but not earnings) at any time, tax and penalty-free, offering a more tax-smart avenue for emergencies.
  • HSA accounts: Withdrawals for non-medical expenses before the age of 65 are both taxed and hit with a 20% penalty. Make sure you're only dipping into your HSA for qualified medical expenses, where withdrawals are tax-free.
  • PLESAs: Allow for penalty-free withdrawals for qualified emergencies, which individuals self-attest to. Just remember that the tax benefits of a PLESA require staying within the set contribution limits and using the funds appropriately.

Navigating these considerations means always having a clear understanding of the terms and conditions associated with your savings vehicles. In practice, this could mean prioritizing withdrawals from your Roth IRA contributions over your 401(k) to avoid penalties, or possibly choosing a PLESA for immediate emergency access without the tax headache.

It can be challenging to navigate the nuances of these regulations, so when in doubt, consult with a tax professional.

Employer-sponsored emergency savings programs

Employer-sponsored emergency savings programs are becoming a valued component of comprehensive benefits packages, offering employees a critical avenue to prepare for unforeseen financial needs. There are key differences between in-plan and out-of-plan ESAs, as well as their tax implications.

In-plan emergency savings accounts 

These ESAs are built into employees’ retirement savings, often associated with a 401(k). They allow employees to save for emergencies while benefiting from the same payroll deduction convenience as their retirement savings. As we’ve mentioned, PLESAs under SECURE 2.0 provide a tax-advantaged emergency fund that, while capped at $2,500, doesn’t incur penalties for withdrawals. Despite their limitations, in-plan ESAs can be a low-entry way for eligible employees to start saving. 

Out-of-plan emergency savings accounts

Out-of-plan ESAs are separate from retirement accounts and often come with no cap on contributions. These accounts offer more flexibility for savings amounts and accessibility and can be offered to any type of employee, including temporary and part-time workers. It’s important to note that they lack the tax advantages of in-plan options. 

For more details on the benefits of out-of-plan ESAs for both employees and organizations, read our article.

Both in-plan and out-of-plan emergency savings programs can impact individual and business tax liabilities: 

  • Employees benefit by building a critical financial safety net, potentially with tax-free growth (for in-plan ESAs) 
  • Employers can attract top talent by offering a comprehensive benefits package that includes flexible emergency savings options

For employers, these programs reflect an investment in the financial wellness of their workforce, which can translate into a more focused and less financially stressed employee base.

Navigating tax implications for financial success

While emergency savings are a cornerstone of financial security, integrating them into your tax planning can enhance their value and protect your interests. With careful consideration and strategic action, you can build a buffer against life's uncertainties in a tax-smart way and help establish your financial success.

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