As we and others have discussed many times before, Roth IRAs basically rock. They’re the gold standard of retirement accounts. You pay taxes on your money before contributing, put the money away for years, and NEVER pay taxes on withdrawals taken in retirement – so your gains are tax-free. In addition, the money you put in is always yours to take back, tax- and penalty-free. With other accounts, your money is totally locked up until you turn 59 1/2. Withdrawals at that time are taxed as ordinary income, and if you want your money sooner, you’ll have to pay a 10% penalty as well.
If you’re currently under-funding your retirement accounts, it’s probably because you have too many goals and can’t fund them all. You have to prioritize, and somehow retirement always gets pushed to the bottom – since, after all, it’s light-years away. What’s more, everywhere you look someone is pushing you to beef up your emergency fund – and you just can’t do that AND fund retirement accounts. Because of the flexibility of a Roth IRA, many people consider using their Roth as an emergency fund (or depositing their emergency fund into a Roth if you prefer to look at it that way). But this strategy is certainly not for everyone. Read on to decide if it might work for you.
Why your Roth SHOULD be your Emergency Fund…
- You can save for retirement now instead of later. If you wait to save for retirement until you have a fully-funded emergency fund (6-9 or even 12 months of living expenses), you might be waiting for years. If you decide to let your Roth BE your emergency fund, you can start contributing right now. Since you can only contribute $5,000 per year, missing years can really have an effect on the total amount you have available at retirement.
- You can possibly enjoy higher gains – and they’re tax free. If you put $5,000 (the Roth IRA limit) into a savings account right now, it will earn you around 1% per year, and you’ll have to pay taxes on that amount. If you put it into a Roth and invest in some good index funds, you might see gains of 6-10%, and they’ll be tax free.
- You might rethink your definition of “emergency.” Most people keep emergency funds in a savings account, or maybe CDs. It can be a little too easy to tap into those funds if, say, you’re a little over your vacation budget or forgot to factor your child’s birthday party expenses into this month’s budget. Keeping the funds in a harder-to-access Roth IRA might make you rethink spending that money.
- In a true emergency, you’ll tap it anyway. Regardless of how much we segment our money (on paper or in actual separate accounts), in a truly massive emergency all funds are emergency funds. If you have a small Roth and a small emergency fund and your emergency fund runs out, you’ll likely take what you can out of the Roth anyway. You might as well benefit from putting it in the Roth now (for reasons 1 and 2 above).
…And why it shouldn’t
- You could be sacrificing your future. The biggest reason for not using your Roth as an emergency fund is because it’s a retirement account, made up of funds you should use when you actually retire and have no other source of income. If you take it out now, it’s not growing for later. And you can’t count on being able to put it back later since the maximum contribution is fairly small – once you take out the money, it’s likely out for good.
- It’s not guaranteed. If you’re putting money in a Roth, you’re probably investing at least some portion of it into the stock market. And if there’s anything the past few years (should) have taught us, it’s that stock market gains are NOT guaranteed. If you put in $5,000 this year, it might be worth $5,500 next year…or it might be worth $4,000 or less. So while you are allowed to take out amounts up to the amount you contributed, there’s no guarantee that amount will actually still exist when or if you need it.
- It’s not liquid. If you have a true need-cash-now emergency, a Roth IRA won’t help you. It will take at least a few days to make the withdrawal and have the funds wired to your bank.
I think a Roth IRA should never be your primary emergency fund OR your primary retirement account. After all, you can only put in $5,000 per year (adjusted for inflation). Even if you save the maximum every year, it’s probably not going to be enough to completely fund your retirement. Instead, you’ll likely rely on some combination of Social Security, a 401(k) or other employer-sponsored plan, and (if you’re lucky) an employer pension. If your Roth represents a small portion of your overall retirement portfolio, it’s probably okay to let it double as your emergency fund – with one caveat. No matter what, I would always keep at least $1,000 in an easily-accessible (read: brick-and-mortar) bank account. You want to be able to hit the bank or ATM if you really need cash in a pinch. Beyond that, I would try to contribute as much as possible to a Roth – while promising to only tap it for true, TRUE emergencies (like a major illness, job-loss or emergency trip). You should still try to build up a dedicated emergency fund over time, but rest easy knowing that you’re not putting off retirement savings because of it.
What do you think – have you successfully used your Roth IRA as an emergency fund? Tell us in the comments!