This article was last updated on October 27
Have you considered using your Roth IRA as an emergency fund?
In this era of tight budgets, a lot of people are finding it difficult (if not impossible), to save for retirement and maintain an emergency fund. Because of this, it’s become trendy to recommend using your Roth IRA as a sort of de-facto emergency fund. Why? Because your Roth IRA provides you with the unique opportunity to both save for your retirement and make early penalty-free withdrawals.
Withdrawing Roth IRA Principal Contributions
While early withdrawals (those prior to age 59½) from your 401k or Traditional IRA most often trigger income taxes and a 10% early withdrawal penalty, that’s not always the case in regard to your Roth IRA.
You can always withdraw the original principal contributions to your Roth IRA tax-free and penalty-free at any time and for any reason.
Since you make Roth IRA contributions with after-tax dollars, those dollars aren’t subject to income taxes if you withdraw them early. Furthermore, the IRS doesn’t levy the normal 10% early withdrawal penalty when it comes to withdrawing your Roth IRA contributions.
This isn’t true when it comes to your Roth IRA earnings (such as capital gains, interest, dividends, etc.) or any traditional IRA conversion amounts. But it is true for the regular annual contributions you make to your Roth IRA.
For example, let’s say you’re 25 years old, you opened a Roth IRA in 2008, and you’ve made the maximum annual contribution each year.
You now have $40,000 in your Roth IRA – $25,000 in original contributions, $7,500 in earnings, and $7,500 from a 401k you converted.
Under IRS rules, you can withdraw up to $25,000 tax-free and penalty-free, because that’s how much you originally contributed. But every dollar beyond that – what you earn on the contributed funds – is subject to income taxes and a 10% early withdrawal penalty. This is because your Roth IRA earnings, like 401K and IRA earnings, are tax free.
3 Potential Pitfalls
Because withdrawing Roth IRA principal contributions is a tax-free, penalty-free event, it’s becoming an acceptable practice to have your Roth IRA double as your emergency fund. However, at least three potential pitfalls exist if you decide to go this route:
1) Liquidity / Accessibility – Odds are that you aren’t using your Roth IRA to invest in cash. In all likelihood, most of your money is invested in mutual funds, index funds, or individual stocks and bonds.
As a result, getting your hands on your money won’t be as easy as stroking a check, clicking the “Transfer” button in your online banking account, or making a trip to the ATM.
When an emergency does strike, you’ll have to sell some of the assets in your Roth IRA in order to convert them to cash. In some instances, this may take as long as 24-hours. And what if your emergency hits on a Friday afternoon? You’ll have to wait until markets open on the following Monday in order to sell, and so it may be as late as Tuesday before you have cash in hand. And that assumes there isn’t an additional time delay for transferring cash from your brokerage account to your bank account!
On top of all that – what if the market is in the midst of a major decline when you need to tap your emergency fund? Do you really want to put yourself in the position of being forced to sell your assets in a declining market?
These are just a couple of reasons you might want to reconsider the idea of using your Roth IRA as an emergency fund. A good emergency fund is a source of liquid and easily accessible cash, and your Roth IRA is unlikely to meet this standard.
2) You’ll Use It – The mere act of deciding to use your Roth IRA as an emergency fund places your retirement savings at risk. Why? Because your mindset has changed from one of having an urgent need to establish an emergency fund to one which banks on you not needing your emergency fund “at the present time.”
By labeling your Roth IRA as an emergency fund, you’re counting on not needed to use it until you can establish a real emergency fund. But the nature of emergencies is that they’re unpredictable. So in all likelihood, you’ll end up using your emergency fund – meaning you withdraw your Roth IRA contributions in order to fund an “unforeseen” emergency. Or worse than that, in an effort to avoid withdrawing funds from your Roth IRA, you use a credit card with interest rates higher than you would otherwise earn on your retirement savings.
In short, if you look at your Roth IRA emergency fund as your “ace in the hole” for any run-of-the-mill emergency, you’re going to end up using it. And when you use it, you miss out on an extremely valuable opportunity to save for your retirement.
3) Lost Opportunity – The IRS places annual limits on Roth IRA contributions. For 2013 and 2014, those limits are $5,500 if you’re under age 50 and $6,000 if you’re 50 or older.
If you withdraw funds you’ve contributed so far this tax year, you still have the opportunity to re-contribute those funds to your account by the April 15th tax deadline (it’s actually April 17th for this tax year). But if you don’t replace those funds or you withdraw your contributions from a previous tax year, you won’t be able to “re-contribute” those dollars.
As a result, you lose those contributions forever, and the opportunity cost of not having those funds invested is enormous.
For example, let’s say you open a Roth IRA in March and make a $5,000 contribution. In December, your car breaks down, and you need $2,000 for a car repair. You take $2,000 out of your Roth IRA, but you don’t put it back by the April 15th deadline, leaving you with just $3,000 invested for the previous tax year.
Invested over the course of 30 years at an annual return of 8%, that $2,000 is really $20,125.31. That’s a lot of money for a car repair! So make sure you realize the implications of using money for an emergency that would otherwise be earmarked as retirement savings.
To summarize, it is possible to use your Roth IRA as an emergency fund. Your annual after-tax contributions can be withdrawn at any time free of income taxes and the 10% early withdrawal penalty.
But whether or not you should use your Roth IRA as an emergency fund is a personal decision. If you decide it’s a good idea, make sure you understand the potential pitfalls associated with your decision.