Using a Roth IRA as an Emergency Fund

This post generated some interesting discussion regarding the finer details of taking early withdrawals from a Roth IRA account. I wrote a follow-up that takes a closer look at the IRS docs to determine, with confidence, the legality and tax implications of early Roth withdrawals. Take a look, Early Withdrawal from Roth IRA Contributions, a Closer Look.

An often espoused first step in gaining control of one’s finances is establishing an emergency fund. From that one pretty annoying finance guy to nearly everyone’s financial idol (bottom of page 22), everyone seems to agree that an emergency fund is a good idea. But where is the best place to put it? This question is particularly of interest to people who are trying to ensure that every dollar is being put to its optimal use.

The Usual Emergency Fund Spots

The most frequently recommended place for an emergency fund is in a savings account. The money is completely safe, even guaranteed by the US government via the FDIC, but it is also completely stagnant.  The average bank interest rate on savings accounts right now is only 0.21% (with rates as high as 2% if you jump through some hoops and are ok with non-liquid funds). This makes a savings account not the ideal location if you are looking to optimize your finances.

Certificates of deposit (CDs) are also often thrown around as a good place to stash your emergency fund, but they tend to be less liquid as well. This liquidity issue can be managed to a certain extent by setting up a CD ladder, but the rates of interest on CDs are not much better than a savings account. Somewhere hovering around 1% nationally. Again, this isn’t an optimal location for your dollars.

So are there alternatives to a savings account and a CD ladder?

Using a Roth IRA as an Emergency Fund

This will really rub some people backward, but bear with me for a second. It is a more efficient use of your money to consider the principle contributions to your Roth IRA as your emergency fund and take the money that you have been considering as an emergency fund and put it to better use somewhere else. Here’s how it breaks down.

Per IRS Publication 590, the contributions to a Roth IRA are allowed to be deducted, penalty free, at any time. IRS Pub. 590 directs you, eventually, to IRS Form 8606 Part III, which is used to calculate your tax liability of Roth IRA distributions. If you care to take a closer look you’ll see that line 19 is your total distribution for the year and line 22 is your total contribution to all Roth accounts since 1994. Line 22 is subtracted from line 19 to determine the amount eligible for taxes. As long as you withdraw less than your total contribution, you are not subject to any income or penalty tax on withdrawals from your Roth IRA. So any money you have contributed to your Roth IRA can be withdrawn, right now, penalty free. The only caveat is that you cannot touch the earnings of those contributions; those must stay in the account until you are 59 1/2 years old.

Using contributions to a Roth IRA as an emergency fund is especially useful for people who have other important uses for their dollars, like paying down debt or saving for a large expense (college, house, vacation, etc.). These people have a “pot” of money in a savings account acting as an emergency fund and another “pot” of money sitting in a Roth IRA acting as a retirement savings. If we consider the “pot” in the Roth IRA to also be the “pot” of emergency funds too, we suddenly have an unused pot of money to throw at debt or whatever. Making your dollars perform more than one job is very powerful.

This strategy is particularly useful for young people, or anyone really, just getting started with retirement savings. It makes more sense to place money into a Roth IRA instead of an emergency fund. By contributing to the Roth, you are using those dollars as both retirement savings and emergency fund. Sure, if your car breaks down and you need to take that money back out of the Roth IRA, shucks, but you’ve lost nothing in the process and instead, stand to gain significantly if your car never breaks down. Compounding interest in a tax advantaged account is a wonderful thing.

I can tell that some of you are not convinced, let’s look at two examples:

  1. Scenario A: Jim makes $35,000 a year, after paying all his bills he has $1,000 left over each month to put towards his emergency fund, Roth IRA, and student loan principle. He decides to put it all in a savings account to get his emergency fund set up. It takes him 18 months to reach his emergency fund goal of $18,000. He has no retirement savings at the end of this 18 months period and he has only paid the minimum amount on his student loan payments.
  2. Scenario B: Jim makes $35,000 a year, after paying all his bills he has $1,000 left over each month to put towards his emergency fund, Roth IRA, and student loan principle. Jim decides to contribute $450 a month to a Roth IRA, $550/month to a savings account. At the end of the same 18 month period described in Scenario A above, Jim will have somewhere in the neighborhood of $8,428 in the Roth IRA (using a rough estimate of 5% annual return on the Roth IRA) and $9,900 in his savings account for a total of $18,328, $328 more than Scenario A and with the exact same amount of liquid assets available for an emergency.

This is the very definition of financial optimization.

Larger Risk

It goes without saying (but I will anyway) that this strategy presents a larger amount of risk relative to the savings account alternative. We all know that money in the market is subject to the movement of the market. However, this risk is lessened as one ages and the balance of Roth IRA contributions grows. This risk can be mitigated by investing the emergency fund portion of your Roth IRA in something ultra conservative, like a whole market mutual fund (admittedly not that conservative) or US Treasury bills.

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