Should I Keep My Emergency Funds in a Roth IRA?

In last week’s blog post, we examined the flexibility of Roth IRAs. Perhaps the most appealing feature of Roth IRA accounts is the tax-free growth of earnings. If you expect to be at the same or a higher tax bracket, the Roth IRA is definitely worth considering based on the prospects of future tax savings. Even if you don’t have a strong opinion as to where your future income tax bracket will be when you need access to your funds, it may prove beneficial to have this added feature of tax diversification.

But tax-free growth of investments isn’t the only driving force behind the decision to contribute to a Roth IRA. Many people, including this writer, also like the flexibility that Roth IRAs provide when it comes to accessing your original contributions. While earnings only grow tax-free if your account has been opened for at least 5 years and distributions occur after age 59 1/2,  your contributions have already been made with after-tax dollars so they can be taken out any time without tax or penalty.

This creates an opportunity to use a Roth IRA as a supplemental emergency fund. It’s a widely debated option and should only be used as such in certain situations. Here are some guidelines for using a Roth IRA as part of your emergency safety net:

Determine your emergency fund goal. Most financial planners recommend keeping at least 3-6 months’ worth of living expenses in an emergency fund. If you’ve had a major life event that had a surprise price tag attached to it, you understand why an emergency safety net is so critical. But it’s a bit scary to hear that according to our most recent research report, just over half of the employees said they actually have one.

So if you fall into to the category of those with a less than ideal emergency fund, you may be faced with the challenging decision of whether it’s best to build up short-term savings or start saving for retirement. You can use this saving for goals calculator to see how long it will take to get your safety net account to its desired amount.  Just remember that an emergency fund goal should be separate from other short-term savings goal such as a car replacement fund, vacations, or savings to buy a home.

Establish a starter emergency fund if you aren’t at your ideal goal amount right now. After looking at your personal spending plan, it may be a bit frustrating to see how long it takes to fully fund your safety net account. My general preference is to first establish a “starter” emergency fund if you don’t already have 3-6 months in emergency savings. The key is to first focus on an initial goal of funding a “starter” fund with at least $1,000 to $2,000 in a separate account from your everyday checking. This starter fund could be a savings, money market, or high yield rewards checking account.

Pay down any high interest debt.  Avoid the temptation to immediately turn to a Roth IRA after your “starter” fund is rock ‘n rolling. If you have high interest credit card debt, your money will usually work harder for you in the long run if you focus on paying off debt versus savings.  Along the same lines, you should also be contributing up to your employer match in a retirement plan at work if one is offered (see “What Comes First: Saving, Investing, or Paying Down Debt?”).

Contribute the maximum amount to a Roth IRA if you qualify, but keep your initial investments ultra conservative. Even for those with the highest comfort level for risk, I believe it is wise to at least have 3 months of living expenses in liquid assets (i.e. easy to access with minimal chance of decline) before contemplating investing your Roth IRA assets in growth-oriented investments that are also geared for emergencies.  Since you want to keep any Roth IRA assets that are specifically set aside for emergencies relatively safe, it is smart to keep these “safety net assets” in short-term conservative investments such as savings accounts, money market funds, short-term CDs, or stable value funds.  Interest rates are NOT exciting right now, but that shouldn’t be the focus of having an emergency fund.

Remember your Roth IRA is not an ATM. The use of a Roth IRA as a supplemental emergency fund provides flexibility but should only be used for genuine emergencies. For someone with a history of raiding a savings account for non-emergencies, a Roth IRA is not the best place to set aside rainy day funds. Fortunately, the fact that you have to complete a withdrawal form to take money out of a Roth IRA triggers the self-thought of whether you have a true emergency or not. If you have the discipline to use the savings for their intended purchase, you can maximize contributions to this account that eventually provides tax-free growth of earnings.

Still not sure if a Roth IRA makes more sense for you as part of your emergency fund? You can use this guide to compare the features of Roth v. traditional IRAs. Just remember that whether or not you decide to contribute to a Roth IRA as part of your emergency fund, the most important thing is that you have a game plan in place to cover any “life happens” moments.

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