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Yes, You Can Use Your Roth IRA as an Emergency Fund – Here’s the Proper Way How

January 28, 2018 by MMD Leave a Comment
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If you’re struggling to save for both retirement as well as be prepared for whatever life throws your way, then here’s something useful for you to know: You may be able to use your Roth IRA as an emergency fund. Here's what you need to know. - MyMoneyDesign.comIf you’re struggling to save for both retirement as well as be prepared for whatever life throws your way, then here’s something useful for you to know: You may be able to use your Roth IRA as an emergency fund.

Yes, because of the unique withdrawal rules for Roth IRA’s, they have the potential to serve double-duty and accomplish both goals.  You can be well-prepared for the unexpected as well as work on building up your future nest egg.

Since these two types of accounts are generally best kept separate, there would be some potential pitfalls to watch out for if you choose to use this strategy.

Let’s take a look at the pros and cons of both sides.

 

Advantages of Using a Roth IRA as an Emergency Fund

Assuming you’re not able to fund your Roth IRA and emergency fund separately, this strategy of combining their forces can give you some unique advantages.

Accessibility

According to the IRS rules, because Roth IRA’s are funded with after-tax money, this makes the contributions portion accessible whenever you want.  You only technically have to wait to touch the earnings part of your IRA (i.e. the money that grew on top of the money you contributed).

This is unlike a traditional IRA or 401(k) where you have to wait until age 59-1/2 to access any part of your savings; contribution or earnings.

Earns Market Rate

One of the big complaints that most people have when it comes to emergency funds is that the money sits around doing nothing.  At last check, online banks were paying somewhere around 1%.  If you compare that to the average rate of inflation at 3%, then it’s almost as if you’re actually losing -2% of your purchasing power every year.

That’s where a Roth IRA can be helpful.  Typically with any sort of retirement fund, you can invest in funds that are going to deliver a much better long-term rate of return than a bank account.  Even a conservative bond fund earning 4% average returns would be a better use of your money.

Tax-Deferred Growth

To build upon the last point, the other thing that using your Roth IRA for emergency funds does is to allow your savings to grow tax-free.

As you may already know, the design of a Roth IRA is that you do not pay taxes on your money in the future since you’ve already been taxed on the contributions in the present. This is the opposite of a traditional IRA or 401(k).

With bank interest or other types of investments, you typically owe some sort of taxes to the IRS.  So by using a Roth IRA, you avoid this completely.

 

Disadvantages

Using your Roth IRA as your emergency fund is not a fool-proof strategy.  There are some potential disadvantages if you’re not careful.

Tapping for the Wrong Reasons

Just because you have access to your money doesn’t mean you should use it.  Retirement funds are intended to be set aside for long-term growth and money in the future.

This is why if you do need to access your IRA funds, you should only do so in the case of “real” emergencies.  Don’t tap your Roth IRA to cover small expenses like unexpected bills or repairs.  For these types of expenses, I’d recommend you keep a small buffer of cash in your savings.  Even $1,000 or so would leave you less tempted to tap your funds.

Hurting Potential Future Growth

The major reason you don’t want to touch your Roth IRA funds if you don’t have to is because it will destroy your future earning potential. 

Those contributions need to be present in order to collect earnings.  If you remove them, then there’s nothing to generate earnings.

Think of it this way: If you’ve got $10,000 set aside in your Roth IRA and it generates 10% earnings, then you’d make $1,000.  Plus it could earn that much or more every year thereafter.  But if you remove $5,000 for your emergency needs, then you only leave $5,000 in the fund.  That means you’re only going to earn $500.  Plus you’ll be crippling yourself for years to come.

Invest Conservatively

While I normally recommend investing aggressively for long-term goals like retirement, if you want to use your Roth IRA as an emergency fund, then you may want to invest more conservatively than you normally would.

This is because when it comes to your emergency savings, you want your money to be around when you need it.  But if you invest aggressively, you have no control over what the markets will do to the value of your savings.  They might go down or up.  And as luck will have it, you’ll probably end up needing them during a down-point.

Tempted to Use the Earnings Too

Remember how we said that the earnings portion of your Roth IRA is off limits?  Unfortunately it could be tempting to withdraw this part of your savings alongside your contributions if you’re in a true emergency situation.  But remember that if you do, you’d be subject to pay the IRS taxes plus a 10% penalty.

 

Conclusions

Again, I’m only recommending this combination strategy if you don’t have enough money to do both.  The best case scenario would be that you find a way to keep your retirement savings and emergency fund separate.  But if that’s not a possibility for you, then this strategy might help you get the best of both worlds.

Remember that as of 2018 each person can contribute as much as $5,500 into your Roth IRA.  That’s $5,500 or $11,000 for a couple as long as you meet the IRS income requirements.  (Actually, you can still contribute to one even if you earn too much – here’s how.)

If you do end up making any withdraws, be sure to report it on your taxes or to your tax preparer.  You will need to fill out IRS Form 8606.

Readers – What do you think about using your Roth IRA as an emergency fund?  What potential advantages or disadvantages do you see in using this strategy? 

 

Photo(s): Flickr

Filed Under: Savings & Budgeting

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