Q:I was wondering what you thought about using Roth IRAs for storing emergency/savings funds? My wife and I are both 40 years old and keep about 2 months emergency fund in a savings/CD account and the rest we are putting into Roth IRAs (one for my wife and one for me). 75% of the asset allocation is Vanguard short-term bonds and the other Vanguard 25% is in stock funds. Additionally we are also building our down payment for our next house in these accounts. If something happened with the market that hit the stocks hard we would have no problem putting off our move. When we do move our current house will be paid off and we will be renting it out. We currently don’t have money that could be directed to the Roth IRA otherwise so we would not contribute to the Roth IRA otherwise. Thank you for all your information and help. I have really enjoyed listening to your podcast and reading your blog.
A:It may seem odd at first to use a retirement account for an emergency fund. Retirement accounts, after all, are designed for long-term saving and investing, not short-term cash management. The unique characteristics of a Roth IRA, however, present some interesting options.
You can withdraw the contributions to a Roth IRA at any time without paying tax or penalty. Remember that Roth IRA contributions are after-tax, so the taxes have already been paid. It’s this feature of a Roth that opens 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 earnings from Roth IRA contributions. A withdrawal of deductible IRA contributions or Roth IRA earnings could trigger taxes and/or a 10% penalty.
Just because a Roth IRA can be used as an emergency fund, however, does it mean it should be used for this purposes. Like most personal finance decisions, there are pros and cons. So before you make your decision, consider the following:
Is a Roth IRA Your Best Retirement Option
Putting aside the idea of using it as an emergency fund, is a Roth IRA your best choice? For some, the better 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 may be far too valuable to pass up. And remember, the annual IRA contribution limit applies regardless of the number and type of IRAs you own. You can’t double the limit by contributing to two IRAs.
Thus, as an initial matter one should 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 place a cap on how quickly you can build an emergency fund in a Roth IRA. For many, the current cap of $5,500 (in 2014) represents more than they could save in a year for emergencies anyway. Further, those that are married can potentially double this amount. But it’s worth keeping in mind that there are limits to how much you can save inside a Roth each year.
Investing Choice Conflict
Deciding to use a Roth IRA for emergencies is just the first step. You also need to decide how you will invest the money inside the Roth.
If you’re saving for an emergency fund or house that you’re going to buy in a few years, you’re generally investing that money very conservatively. You don’t want to put short-term cash in stocks because of potential market fluctuations. For emergency funds, such conservative investing is appropriate.
However, it’s another story when it comes to long term retirement investments. Assuming you’re going to retire at a traditional age of 65, a heavily weighted bond portfolio would be too conservative for most people. Therefore, you’ll need to decide whether how you’ll treat the money for investment purposes. Is it for an emergency fund (invested conservatively), 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, it may require you to sell investments in a down 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 make too much to qualify for a Roth IRA. While that’s a “good” problem to have, 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 begins to tick. In other words, it marks the commencement of the five-year rule that applies to contributions. While this alone doesn’t justify using a Roth for short-term savings, it is one advantage of opening an account.
Doesn’t Work with Conversions
A Roth IRA doesn’t work as an emergency fund if it is funded with conversions from a traditional IRA. As we recently covered, there is a 5-year rule that applies to amounts converted to a Roth IRA. Take out those proceeds before the 5-year rule is met and you may be hit for a 10% penalty.
In a nutshell, a Roth IRA can be used for short-term savings. In fact, it may be a good way to get started with a Roth IRA rather than putting as much money in a savings account for emergencies. Ultimately, a Roth IRA is a viable emergency fund option, but it does have some issues that you ought to think through before going down that path.