Should you keep your emergency 'cash pot' inside an ISA?

In the UK, we can put up to £20K into a tax-free ISAs each year and any capital gains are completely tax free.

Emergency cash pot

Many people (and particularly the self-employed) will have an emergency 'cash pot' which they can withdraw cash from should an emergency arise, such as if being unable to work due to accident or health, loss of job, unforeseen expenses, etc. 

If you need to withdraw funds (e.g. due to temporary loss of income) it is best to withdraw from your emergency cash pot which typically holds at least 3-6 months of income rather than sell your high-gain stocks/ETFs and be out of the market.

Unless you are retired and are drawing a good pension, you may need an emergency pot that is large enough to support you for at least 6 months or so, especially if you don't have any other 'cash' resources.

This pot should not be invested in volatile assets because it needs to be available at all times - if you invested it in the S&P500 and the stock market went down 50% just when you needed the cash, you would only have half the emergency funds you thought you had!

When the s*it hits the fan...

If I did not have an emergency cash, and I simply invested in normal stocks and shares AND I needed to draw money out just at the time when there has been a 'correction' or recession in the market (as happened in 2001, 2008, 2020) then this would have a seriously damaging affect on my future gains. It may also trigger capital gains taxable events if I was forced to sell some of my shares.

An 'emergency' or 'cash' pot should be invested in safe and stable funds which will not be affected by market fluctuations. Suitable vehicles are:

1. Savings accounts (e.g. bank or cash account paying interest such as Trading 212 5.1%)
2. Money Market Funds (e.g. MMF ETF) (5%ish)
3. NS&I Premium Bonds (4.4%)
4. Cash ISAs (Trading 212 5.1%)
5. Gilts/Bonds 1-4% (may be tax efficient for high income tax payers - see here)

I prefer options 1 and 2 to hold 'cash' as these tend to give better interest rates while being readily accessible. However, outside of an ISA, option 1 will/may incur/add taxable interest every year (1k tax allowance) especially if I also have other savings accounts earning interest, whereas if I save money in an MMF ETF (similar 5%/yr rate), I would create a taxable (CGT) event, only if and when I sold that ETF when needed in an emergency (£3k/yr CGT allowance).

But what if I have filled my 20K ISA allowance and also have other savings and investments as well?

This MMF ETF (e.g. CSH2 paying 5%) could be kept within my ISA, but this would use up my ISA allowance. For instance, I might need to build a £20K emergency fund (to pay mortgage, council tax, food, fuel and energy costs, etc.) then I would have used up £20K of tax free allowance on an emergency pot that might earn approx 5%, whereas I could have held a global or S&P500 ETF in the ISA which would gain 10%-25% tax free each year instead.

In the UK however, I can realise up to £3K of Capital Gains without paying CG tax. So I could have up to £60k in a General Investment Account (GIA) with a 5% return from a MMF ETF and withdraw all that £60k (£3k gain) in one year without incurring any tax penalty. Note that some money market ETFs and gilts may also be liable for income tax which you must pay each year (ERI) if not in a tax-free wrapper. Gilts (e.g. TN25, etc.) may be a better CGT tax-free option in some cases (via Hargreaves Lansdown or Interactive Investor).

So, if you already have or will maximise your ISA allowance each year, it may be better to keep your rainy day 'cash' pot in your GIA account and build it up over a few years, because when you have an emergency, that fund will have kept up with inflation and withdrawals will still be tax free (depending on current gov. rules). Even if the government reduce the CGT allowance to £1k, the CGT rate would have to match your income tax rate (10% vs 20% at the moment) for you to be worse off than using a savings account.

Of course, if the government changes the CGT allowance and increases the tax rate in the budget at the end of October 2024, then many people might opt to keep their emergency fund as tax free Premium Bonds instead (max £50k)!

Keeping a cash pot also has other advantages when there is a big stock market correction or recession which happens every 2-4 years. Then it is a good time to buy stocks at a lower price and you will have the 'spare' cash in your emergency 'pot' to take advantage of that. So even though the value of your portfolio will drop in a recession, you can feel better knowing that you are buying on the cheap!