Many financial advisers recommend having at least a three-month emergency fund before focusing on retirement savings. This is sound advice with many retirement plans that make your money completely inaccessible or charge hefty fees for accessing it. However, if your income allows you to contribute to a Roth IRA, you can kill two birds with one stone.
Using a Roth IRA As An Emergency Fund
Why You Shouldn’t Wait to Save for Retirement
Most retirement options are use it or lose it. With a 401(k), you might miss out on an employer match if you don’t contribute to the fund. With a Roth IRA, there is an annual contribution limit. If you don’t contribute the maximum each year, there’s no way to catch up, and you permanently lose the tax advantages that come with Roth IRAs.
Is a Roth IRA Too Risky for an Emergency Fund?
A Roth IRA is only as risky as your investments, so there’s no reason it can’t be safely used as an emergency fund. Instead of investing in the stock market, you could use a mix of bonds, money market funds, bank CDs, or cash. Your exact options will depend on the broker, but you have full control over how much risk you take — or don’t.
What Happens When You Need the Money?
You’ll have instant or near-instant access to your money. Any cash funds can be transferred to your checking account, usually within two to three business days, and immediate wire transfers are also often available. Some brokers even allow check-writing privileges on Roth IRA accounts.
If you’ve invested your funds, most investment products can be instantly sold during market hours although there may be an additional one or two-day settlement period before you can withdraw the funds. Watch out for early withdrawal or frequent trading fees on certain investment options and be aware that some securities may have a minimum holding period during which they can’t be sold. The best course of action is to avoid these investments altogether when deciding how to invest your emergency funds.
The Costs of Withdrawing Funds from a Roth IRA
One of the biggest advantages of using a Roth IRA for an emergency fund is that you can withdraw your contributions without penalty and without taxes because they were already taxed. Only your investment earnings are subject to taxes and penalties if you withdraw them before age 59 1/2. The penalty is 10 percent, and the tax is your regular income tax rate. Contributions are considered to be withdrawn first, no matter when made, so you would only be penalized for withdrawing investment earnings after you’ve withdrawn every penny you contributed to the Roth IRA.
The downside to withdrawing funds from a Roth IRA is that you only have a limited amount of time to replace them. You have 60 days to redeposit the funds without them counting towards the current year’s contribution limit. After that, they’re withdrawn forever. If you need an extra incentive to put your money back into your Roth IRA within the 60-day limit, doing so waives any taxes and penalties that would have applied.
What You Gain
If you contribute up to the limit and never have an emergency, you now have a maxed out retirement account. As your regular savings account grows, you can begin to consider that your emergency fund and start to invest the money in your Roth IRA more aggressively.