I put 2% of my paycheck into a savings account.
I then put 23% into a 401k (my company matches up to 3%).
And then I put about $2,000 a year into a college fund.

If I ever lose my job, ill go back to school, and use the savings account to eat deli sandwiches with. And since my 401k is a retirement fund, I will qualify for govt assistance, and then cash it out once I get my school paid for. I would probably join a fraternity from there, and get free housing.

I’m curious why you’re immediately dismissive of this option “Bad idea in general…”. I think it’s an excellent way to save on taxes for someone who otherwise would not max out a retirement account for a given year. Is there anytime in particular you don’t like about the idea?

In my case, mine is the only income to support my wife and two small children. 2009 was the first year we’ve ever maxed out both our ROTH IRAs (I contribute to my 401(k) to receive the maximum company match). The fact that much of the money came from our emergency fund didn’t impact our retirement savings for 2009. We had already contributed what we planned for the each for each ROTH, then made up the rest of the $5,000 limit from our emergency cash. Our current retirement savings percentage (without maxing both IRAs) is 15% of my gross earnings. It would be great if we managed to earmark $10K strictly for retirement into our IRAs, but that just isn’t possible right now, so I might as well “stash the cash” somewhere it’s protected from taxes.

The strategy described by the book is to keep at least 10% (my goal is actually 15%) of annual income in a checking/savings/cash account to cover unplanned large expenses, such as when a vehicle needs emergency repairs or a family member takes a trip to the ER. On top of the readily-accessible cash account, set aside 20% of annual income in retirement accounts (ROTH for those who qualify). This is the true emergency fund, only to be accessed due to a major life event, such as significant injury, illness or loss of job. If the emergency fund needs to be tapped, chances are it will be the major source of income, and therefore the tax penalties for removing funds will be diminished (and zero if using a ROTH and only removing contributions). The emergency funds should be in “stable” investments such as CDs, US Treasuries, money market funds or inflation protected securities. You’re not trying to hit a home run with this, you want the money there if you need it.

I am still in the process of getting this all set up (I’m about half done – it takes time due to contribution limits on retirement accounts). I’m going with a 50/50 split of local credit union ROTH CDs and the Vanguard TIPS index fund.

I like this approach for three reasons:
1) I avoid taxes on the earnings.In this interest climate it’s a minor concern, but I don’t believe interest rates will stay this low over the long term.
2) The money is not readily accessible. It’s a cushion against the truly difficult times in life, not an account to pull money from to pay for whatever seems like the “emergency” of the moment.
3) If I never tap this emergency fund, I have gained a lot of money to use in retirement, tax-free (for ROTH accounts). This is not money I typically include in figuring how much I have saved for retirement, so if it’s still there in 30 years, I just got a bonus!

I’m happy with this solution, but I’m very interested in what others have to say.

I had a question. While Roth contributions can be withdrawn penalty free, should we track other things? For instance, if I have only made one $1000 contribution 2 years ago and this is now valued at $960 which includes $60 of dividends, can I withdraw -penalty free – the whole $960 or only $900 (i.e. less $60 of dividends)?