Muni bond funds for a portion of emergency fund?

If muni bonds make sense for your tax situation, which usually means a total tax rate of 35%+, then your entire EF should be in short-term munis.

I don’t have CA-specific funds memorized, but at a federal level (all I need to worry about), the best choices I’ve found are FMNDX and MEAR.

The idea of shielding the cash in a tax-deferred vehicle is interesting. I would still need to have enough in my taxable account to cover any actual emergency during a market drop (which I currently do not) or be willing to draw down Roth basis. Which I totally could do, it's just psychologically difficult. (Since I have access to the Mega Backdoor Roth 401k, I've been dumping money into my Roth vehicles rather than a taxable brokerage.)

Emergency funds are always presented with capital preservation taking precedence over tax optimization, but there's definitely a point where your assets as a whole are large enough that even a catastrophic market drop would still leave you with enough to cover an emergency (and my Roth basis + HSA receipts are large enough). Then the difficulty is selling during a market drop. But the concept of an asset swap mitigates that; it's mathematically the same as withdrawing from a HYSA in terms of your overall portfolio. I guess I'd just never thought of my emergency fund as part of my portfolio, but it is.

Two questions: 1) are we getting into tax tail wagging the dog territory here? I'm at the 32% bracket bordering on 35%, so let's say worst case scenario 35% federal plus 9.3% state plus 3.8% NIIT = 48.1%. $45k in HYSA earning let's say 4% is $1800/year in interest which is about $865/year in taxes. Is it worth keeping track of all this to save a good chunk of that $865/yr? Maybe?

2) I highly doubt I could get as high returns on my cash inside a retirement vehicle as outside. There's a bunch of accounts at different banks that will give you 5% APY up to $1000 or $2000. My current e-fund (about $30k, 6 months of lean spending) is split between these accounts and I-bonds plus a couple thousand at my primary bank, and is getting roughly 4.2% overall. Does tax protection outweigh higher yields?

Muni bonds start to make tax sense the higher your tax bracket. If you're in the 32% (just guessing from your spend), then muni bonds are a reasonable strategy for cash.

Even with escaping tax from the muni bonds though, $45K in a HYSA is going to be a tax drag. Instead of a mix of HYSA and muni bonds, or at least in place of the HYSA, you might consider moving your cash allocation into a tax-deferred account like a 401k or IRA to shield the cash's dividends from annual taxes. This is the same suggestion as Joe's #2. You don't need to have access to distribute from the tax-deferred account in order to access the cash. You can use an asset swap with another account you do have access to take withdrawals from, like a taxable account.

The way an asset swap works between a tax-deferred account and a taxable account is you sell shares of something in the taxable account—let's say $5K worth of VTI—and withdraw that $5K to spend. Now in your tax-deferred account, you use the cash that's there to buy $5K worth of VTI. You've accessed the $5K cash you need to spend without changing your overall asset allocation across the portfolio. Whether VTI is up or down on the day you execute the swap, you're selling and buying at the same price, so no net change in the portfolio's value other than the $5K you withdrew.

Hey Westie, so can I ask a question… why bonds? Is this cash you need in the next 5 years or just building reserves? Remind me where you’re at in your accumulation. A few ideas to chew on.

1. If stable job, just keep 1-2 mo worth of cash in a savings or money market for ease (don’t worry about chasing yield) and rest put into equities in your brokerage
2. If set on having bonds, then add the bonds into your 401k/IRA so no taxes in the yield and then do equities in your brokerage. This will limit taxes altogether (minimal qualified dividends). This still gives you the cash reserves you’re asking about but in a more tax efficient way And if you need the cash you do an asset swap.
3. If it’s cash you plan to spend in the next 1-3 years then sure, muni bonds can be useful to reduce some tax burden but for what you’re talking, it’s a few thousand saved on taxes. If cash for 3-5+ yrs then maybe put that portion into a risk parity style portfolio to get some growth and limit drawdown.