Should a Roth IRA Be Part of Your Emergency Safety Net?
June 02, 2014Roth IRAs are increasingly becoming one of the most popular savings vehicles for retirement. The most appealing feature of the Roth IRA is that these type of retirement accounts offer tax-free withdrawals of earnings at age 59 ½ as long as the account has been open for at least 5 years. The term “tax-free” is quite appealing in the current economic environment where higher future income tax rates appear to be a real possibility. Millennials and Gen Xers, who may not be in their peak earning years, may be particularly prime candidates to contribute to a Roth IRA. Perhaps that is one reason why the growth in Roth IRAs far outpaces that in traditional IRAs as more account owners are choosing to use after-tax dollars to save for retirement to receive the tax break during retirement.
In addition to tax-free withdrawals of earnings during retirement, there is another added bonus that comes with investing in a Roth IRA. The ability to withdraw contributions at any point in time without having to pay any taxes or penalties is a big plus for disciplined individuals who don’t simply view the Roth IRA as a short-term savings account. This is an often misunderstood aspect of Roth IRA rules so it’s important to understand how this may impact you if you have or plan on establishing a Roth IRA account.
Let’s take a look at how this could impact you. If you contribute the maximum amount to a Roth IRA today ($5,500 if you are under 50) and your account grows to $6,000 by the end of the year, you can still withdraw your original contribution amount without paying any taxes or penalties. As long as you leave any earnings in the account ($500 in this example), you will not have created a taxable event. You just have to complete a withdrawal form that can also help to discourage you from raiding the account for frivolous purposes. The advantage is that anything you don’t withdraw can grow to be tax-free after age 59 ½ (and having the account for at least 5 years).
One frequent question that I often get regarding Roth IRAs relates to this flexibility – should a Roth IRA be included as part of an emergency fund? Knowing that you can always access your original contributions without paying taxes is appealing for many people who are trying to save for emergencies and retirement at the same time. With so many different moving parts in our financial lives, it can be difficult choosing how to prioritize among financial goals that are competing for the same limited resources.
Should we save for retirement or save for emergencies? This is a question that can be a little more complicated than it seems but it doesn’t necessarily have to be. My perspective is why not save for both? A Roth IRA can be an excellent retirement savings vehicle that also provides enough flexibility to be used for emergency savings. In many cases, a Roth IRA can also be used to supplement college funding needs. Each scenario requires some special guidelines.
In summary, it is my opinion that Roth IRAs can be used as a supplement to your emergency savings with special guidelines and restrictions. Next week, we’ll take a look at specific ways to potentially incorporate Roth IRAs into your short-term emergency fund while also supplementing your long-term retirement savings.
Until then, what are your thoughts? Do you consider a Roth IRA a legitimate option to help pay for any unforeseen “life happens” expenses? Leave your thoughts in the comments section below.