Should you use a Roth IRA as an emergency fund?

0

Should you put your emergency fund in a Roth IRA? If you are considering this option, you are not alone. Here’s an email from a reader named Thomas asking if it’s wise to rely on Roth IRA in an emergency:

Question:I was wondering what you think about using Roth IRAs to store emergency / savings funds? My wife and I are both 40 and keep about 2 months of emergency funds in a savings / CD account and the rest we put in Roth IRA (one for my wife and one for me). 75% of the asset allocation is short-term Vanguard bonds and the remaining 25% Vanguard is equity funds. In addition, we are also building our down payment for our next house in these accounts. If anything happened with the market hitting stocks hard, we would have no problem delaying our decision. When we move out, our current house will be paid off and we will rent it out. We currently have no money that could be directed to the Roth IRA otherwise, so we would not be contributing to the Roth IRA otherwise. Thank you for all your information and help. I really enjoyed listening to your podcast and reading your blog.

A:It may seem strange at first to use a retirement account for an emergency fund. Retirement accounts, after all, are designed for long-term savings and investing, not short-term cash management. The unique characteristics of a Roth IRA, however, present some attractive options.

You can remove the contributions to a Roth IRA at any time without paying taxes or penalties. Remember that Roth IRA contributions are after tax, so taxes have already been paid. It is this characteristic of a Roth that opens up the possibility of using contributions as a source of funds in an emergency. Keep in mind that this doesn’t work with a traditional deductible IRA or any other earnings Roth IRA contributions. A withdrawal of deductible IRA contributions or Roth IRA income could trigger taxes and / or a 10% penalty.

Just because a Roth IRA can be used as an emergency fund, does that mean it should be used for this purpose. Like most personal finance decisions, there are pros and cons. So before making your decision, consider the following:

Is a Roth IRA Your Best Retirement Option

Aside from the idea of ​​using it as an emergency fund, is a Roth IRA your best bet? For some, the best choice will be a traditional IRA with deductible contributions. While a deductible IRA cannot be used as an emergency fund (at least without incurring penalties and taxes), the tax deduction can be far too valuable to ignore. And don’t forget that the annual IRA contribution limit applies regardless of how many and what type of IRAs you have. You cannot double the limit by contributing to two IRAs.

So, first, you have to decide whether a traditional or Roth IRA is the best option for retirement savings.

Take note of the IRA contribution limits

The IRA contribution limits limit how quickly you can create an emergency fund in a Roth IRA. For many, the current cap of $ 5,500 (in 2014) is more than what they could save in a year for emergencies anyway. Plus, those who are married can potentially double that amount. But it should be borne in mind that there are limits to what you can save each year in a Roth.

Conflict of investment choice

Deciding to use a Roth IRA for emergencies is only the first step. You also need to decide how you are going to invest the money inside the Roth.

If you are saving for an emergency fund or a house that you are going to buy in a few years, you usually invest that money very carefully. You don’t want to put short-term money in stocks because of potential market fluctuations. For emergency funds, such a prudent investment is appropriate.

However, it’s a different story when it comes to long-term retirement investments. Assuming you’re going to retire at the traditional age of 65, a heavily weighted bond portfolio would be too conservative for most people. Therefore, you will need to decide whether you will be dealing with the money for investment purposes. Is it for an emergency fund (invested prudently) or is it for retirement (invested more aggressively)?

One approach some take is to invest the proceeds in a Roth for retirement. If the money is needed for an emergency, you may need to sell investments in a bear market. Some are willing to take this risk in exchange for the higher returns of a more aggressive portfolio.

Take note of the Roth IRA income limits

Some earn too much to qualify for a Roth IRA. While this is a “good” problem, you’ll want to check the Roth IRA income limits to see if you qualify.

Your 5 year clock starts ticking

Once you start contributing to a Roth IRA, your 5 year clock starts ticking. In other words, it marks the beginning of the five-year rule that applies to contributions. While this alone does not justify using a Roth for short term savings, it is one of the perks of opening an account.

Doesn’t work with conversions

A Roth IRA does not function as an emergency fund if it is funded by conversions from a traditional IRA. As we recently covered, there is a 5 year rule that applies to amounts converted to Roth IRAs. Remove these products before the 5 year rule is met and you could be hit with a 10% penalty.

In a nutshell, a Roth IRA can be used for short term savings. In fact, it can be a good way to get started with a Roth IRA rather than putting so much money in an emergency savings account. Ultimately, a Roth IRA is a viable emergency fund option, but it does come with some issues that you need to think about before you embark on this route.

Share.

Leave A Reply