Financial planners generally say that one of the most important financial goals should be to have enough emergency savings to cover at least 3-6 months of necessary expenses. As long as you meet the income limits (or can get around them without tax issues), one option to consider for your emergency fund is a Roth IRA. Here are 3 reasons why:
No penalty on early withdrawal of contributions
Unlike other tax-advantaged retirement accounts like a 401(k) and a traditional IRA, early (before age 59 ½) withdrawals of contributions to a Roth IRA are not subject to taxes or penalties. Early withdrawals of earnings may be subject to taxes and penalties, but the contributions come out first.
As an example, if you contribute $5,500 to a Roth IRA and that $5,500 grows to $6,000, you can withdraw the $5,500 at any time and for any purpose without tax or penalty but not the $500 of earnings. (Note that any money you convert to a Roth IRA has a 5 year waiting period before it can be withdrawn tax and penalty-free.)
Your money is more protected
The main benefit of a Roth IRA is that those earnings can grow to be tax and penalty free once the account has been open for at least 5 years and you’re age 59 ½. This can essentially shield your earnings from taxes. In the meantime, Roth IRAs also have stronger protections from creditors and can avoid probate when you pass away.
You’re less likely to use it frivolously
More important than protecting your money from creditors, probate, or even the IRS might be protecting it from you. Because of the benefits of keeping it saved in the IRA, you’re probably less likely to spend your Roth IRA frivolously than if that money was in a regular account. (It also doesn’t hurt that you have to fill out a form for each withdrawal).
By contributing your emergency savings to a Roth IRA, you can build your emergency fund without missing the annual Roth IRA contribution limits. One last thing to keep in mind is that you’ll still want to put your Roth IRA money in something safe like a bank account or money market fund if it’s part of your emergency fund. Once you’ve accumulated enough savings somewhere else, you can then invest it more aggressively for retirement.