Using Your Roth IRA as an Emergency Fund — Ever a Good Idea?

By Dan Rafter on 16 June 2016 0 comments

You know you need an emergency fund, that pool of savings that you can dip into to cover the costs of replacing everything from a burst water heater to your car's blown transmission. But does it ever make sense to use a Roth IRA as that emergency fund?

The short answer? It might. If you're careful about your withdrawals.

You usually think about Roth IRAs as retirement vehicles. But with a Roth IRA, you can also withdraw from your contributions at any time without penalty, even if you are younger than 59 ½. That's because you've already paid taxes on your contributions.

No Penalties From Contribution Withdrawals

Because of this quirk, a Roth IRA can work as an emergency fund and retirement fund at the same time. You make your yearly deposits — for 2016, you can contribute a maximum of $5,500 every year into a Roth IRA (unless you are 50 or older, in which case you can contribute a maximum of $6,500 a year) — and watch that money grow as you near retirement. But if an expensive emergency comes up, you can withdraw the funds you need, as long as what you are withdrawing is coming from the money you contributed to your Roth IRA, and not from the dollars that those contributions have earned.

You'll Pay for Earnings Withdrawals

In other words, withdrawing your contributions is never penalized. Withdrawing from your Roth IRA's earnings, though, will leave you with a penalty and a tax hit. If you withdraw the money that your Roth IRA has earned before you hit the age of 59 ½ — aside from a few special circumstances — you'll not only pay taxes on those dollars, you'll also have to pay a penalty of 10% of whatever you withdraw.

Say you withdraw $2,000 worth of earnings on your Roth IRA before you turn 59 ½. Not only will you have to pay taxes on that money, you'll also have to pay a penalty of $200.

Fortunately, it's not easy to withdraw your earnings too early. You'll have to request the withdrawal from your brokerage, mutual fund, or bank. These financial institutions will know if your withdrawal request is high enough to cut into your earnings. If this does happen, it's best to find an alternative source of funds, unless you are not bothered by the idea of paying extra taxes or an additional penalty.

The Annual Cap Means You Can't Pay It Back

There is another disadvantage to using a Roth IRA as an emergency fund. Say you withdraw $2,500 to buy a new furnace. You can still only contribute your maximum to your Roth IRA each year.

If you can only contribute $5,500 each year, you can't make up for that $2,500 withdrawal by contributing $7,000 instead. This could slow the pace of your retirement savings.

You'll also need to be careful with your investments if you plan on using your Roth IRA as an emergency fund. You should place your money in safer, more conservative investment vehicles such as CDs and bonds. That way, the odds are greater that more of your money will be available in case of a financial emergency.

Whether you use a Roth IRA, a traditional savings account, or some other savings vehicle as your emergency fund, one factor doesn't change: You need to build and maintain that fund. How much money you need in your emergency fund varies, but most financial experts recommend that you have at least six months of daily living expenses saved up. More, of course, is even better.

Have you ever pulled money from a Roth IRA to cover an emergency? Would You?

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Guest's picture
JohnM

Dan,

With regard to the precaution with regard to the annual cap and paying it back, according to the MyRA website's tax information section you may be able to pay back a little. Any contribution that is withdrawn on or before the due date (including extensions) for filing a tax return for the year is treated as an amount not contributed. (https://myra.gov/roth-ira/)

That means that for your scenario, if there had already been contributions of at least $2,500 during the year that the furnace had to be replaced, one would have the opportunity to re-contribute that same $2,500 prior to their filing date. Not a huge exception, but one worth considering depending on the timing of contributions.

Cheers,
john