Is a Roth IRA the Wrong Tool for Emergency Savings?

December 08, 2016

I recently stumbled across this blog post called “The Emergency Roth Fallacy,” which criticizes me (along with a host of other financial writers) for advocating the idea of using a Roth IRA for an emergency fund. The basic idea is that since Roth IRA contributions can be withdrawn tax and penalty-free at any time and come out before earnings (which can be subject to taxes and a 10% early withdrawal penalty if withdrawn before 5 years or age 59 ½), you could use a Roth IRA as your emergency fund. Just be sure to keep it somewhere safe like a bank account or money market fund until you’ve built up sufficient emergency savings (at least enough to cover 3-6 months’ worth of necessary expenses) elsewhere. At that point, you can then invest the Roth IRA money more aggressively to grow tax-free for retirement. Let’s take a look at the criticisms:

“Who cares about saving taxes on an account earning 1%!?” I don’t know about you, but I try to save every penny I can from taxes. The bigger point is the opportunity you may have to invest that money later for a higher tax-free return. By funding the Roth IRA while you’re building your emergency fund, you avoid missing the opportunity to stick as much money in a tax-free account as possible.

“Money you withdraw can’t be put back.” Technically, you can put the money back within 60 days one time each year. It’s also no worse than not having contributed the money at all, which would be the alternative for someone who can’t afford to do both. However, I would go further and say that this is actually a benefit of using the Roth IRA as an emergency fund. That’s because the pain of withdrawing money that would otherwise grow tax-free can discourage people from withdrawing money for non-emergency purposes.

“It’s a complex solution to a non-existent problem.” First, the strategy isn’t for everyone. Many people do prefer the simplicity of a simple savings account for their emergency funds. On the other hand, I also know people who are reluctant to build up their emergency savings because they want to get as much money as possible into tax-advantaged accounts like the Roth IRA. This solution can solve that dilemma for them.

“It’s WAY too hands-on.” There are plenty of people (like yours truly) who are willing to take a few extra steps to optimize their finances. It can also be implemented by financial advisors for clients who prefer being more hands-off.

There are some additional benefits of a Roth IRA vs a regular savings account for an emergency fund. The fact that it’s designated as a retirement account and requires extra paperwork for withdrawals can discourage you from tapping into it for frivolous “emergencies.” Some institutions may pay higher interest rates on IRA accounts. Finally, some states provide more creditor protections to IRAs and IRAs avoid the time and cost of probate as long as there’s a living beneficiary.

None of that may matter to you. You may prefer the simplicity and convenience of a regular savings account. But for others, the Roth IRA can be a useful tool in helping them build and preserve emergency savings.