If you’re juggling saving for retirement and preparing for life’s unexpected challenges, there might be a helpful solution for you: using your Roth IRA as an emergency fund.
Thanks to the unique withdrawal rules of Roth IRAs, they can potentially serve a dual purpose. You can prepare for emergencies while also building up your retirement savings. However, since traditional advice suggests keeping these accounts separate, there are some potential pitfalls to be aware of with this approach.
Let’s weigh the pros and cons.
If you can’t fully fund both a Roth IRA and an emergency fund separately, the IRS allows Roth IRA contributions to be withdrawn at any time since they are made with after-tax money. This differs from traditional IRAs or 401(k)s, where you must wait until age 59½ to access any of your savings.
One common complaint about emergency funds is that the money often sits around earning very little interest. For example, online banks typically offer around 1% interest, which doesn’t keep up with the average 3% inflation rate, effectively reducing your purchasing power.
In contrast, a Roth IRA allows you to invest in funds that may yield higher long-term returns than a bank account. Even a conservative bond fund offering 4% could be more beneficial.
Additionally, using a Roth IRA allows your savings to grow tax-free. Because you’ve already paid taxes on your contributions, you won’t owe taxes on them in the future, unlike traditional IRAs or 401(k)s. This advantage extends to avoiding taxes you might owe on other types of investments or bank interest.
However, using your Roth IRA as an emergency fund isn’t a fool-proof strategy and comes with potential downsides. Just because you can access your money doesn’t mean you should. These funds are meant for long-term growth and future needs.
You should access your Roth IRA only in genuine emergencies, not for minor expenses like bills or repairs. Keeping a small buffer of cash in a separate savings account, even just $1,000, can help reduce the temptation to touch your Roth IRA.
The significant downside of tapping into your Roth IRA is the impact on future earnings. Withdrawn contributions can’t generate future earnings. For instance, if you have $10,000 in your Roth IRA earning 10%, you make $1,000. If you withdraw $5,000, your earnings drop to $500, limiting future growth.
For those considering using their Roth IRA for emergencies, it’s wise to invest more conservatively. You’ll want your emergency savings to be available when needed, so avoid aggressive investments that might decrease in value.
Remember, only the contributions in a Roth IRA are easily accessible. Withdrawing earnings before age 59½ can incur taxes and a 10% penalty from the IRS, which can be costly.
This strategy is best used by those who can’t afford to fund both retirement and emergency savings separately. Ideally, you should keep these funds separate. But if that’s not an option, combining them can offer some benefits.
As of 2018, you can contribute up to $5,500 per year to a Roth IRA, or $11,000 for a couple, provided you meet IRS income requirements. Even if you earn too much, there are still ways to contribute. If you make withdrawals, report them on your taxes and fill out IRS Form 8606.
