Roth IRA as an Emergency Fund – Is it a Good Idea?

Roth IRA as an Emergency Fund - Is it a Good Idea

Photo courtesy of Pink Sherbet Photography

A few weeks ago, Grayson over at Debt RoundUp wrote about his plan to use his Roth IRA as a backup emergency fund. It’s something I’ve seen Mario over at Debt Blag write about as well, and it’s a topic I’ve discussed with friends and family in my own life as they’ve considered different options for handling their savings needs.

The concept of using your Roth IRA as an emergency fund is one I find incredibly interesting, mostly because of the mental or behavioral considerations. From a purely technical standpoint, it can make a lot of sense. But from a behavioral standpoint, it can be dangerous when you start mixing your retirement savings with other purposes. Today I’d like to explore some of the strengths and weaknesses of taking this approach.

What is an emergency fund?

At its core, an emergency fund is simply money set aside for the purpose of handling life’s unexpected expenses. But there are two stages to an emergency fund that I think are important to understand when considering whether you should be using a Roth IRA for these purposes.

When you’re starting out, your emergency fund will serve the purpose of meeting the very basic unexpected expenses, such as a traffic ticket or a busted cell phone. It will help you handle life’s little obstacles without blowing a hole in your budget. This is Stage 1.

Over time, however, you should be able to set up separate savings for those little irregular expenses and your emergency fund will start to serve a larger purpose. In Stage 2, your emergency fund is available only for true emergencies, such as unemployment or major medical bills. This is where you try to build your emergency fund to 3-6 months of expenses, or possibly more, and hope you never have to touch it. It’s there as one of your last layers of security only in the case that life really hits you hard.

What is a Roth IRA?

A Roth IRA is a type of investment account that’s designed to help you save for retirement. It’s an account that you open and contribute to outside of your employer, making it somewhat different than a 401(k).

It’s also different from a tax perspective. With a Roth IRA, there are no tax advantages associated with your contributions, but when you take the money out it is 100% tax-free. The specific advantages and disadvantages of a Roth IRA are a discussion for another day, but the main takeaway here is that it’s an investment account specifically designed to save for retirement.

Why can you use a Roth as an emergency fund?

Many retirement accounts, such as a traditional 401(k), have penalties associated with taking the money out before retirement age. This would make them a poor candidate for anything other than pure retirement savings.

A Roth IRA is different in that you are allowed to take out your contributions without penalty at any time. And there are no taxes to be paid either, since there was no tax benefit to your contributions to begin with (though you may also have to withdraw the earnings, which would be subject to taxes. That’s no different from a regular savings account though.). So if I contribute $1,000 to my Roth IRA this year, and some time in the future I decide I need that $1,000 for something, I can take it out without penalty. I could even put the money back in later in the year if my situation improved, up to the annual contribution limit ($5,500 for 2013).

So a Roth IRA has some flexibility to it that other retirement accounts don’t. This flexibility makes it possible to consider using it for purposes other than retirement.

For more technical answers on the treatment of distributions from a Roth IRA, you can refer to IRS Publication 590.

Why you shouldn’t use your Roth IRA as an emergency fund

Below, I’ll get into the situations in which I think that using your Roth IRA as an emergency could be a good strategy and specifically how it should be done. But first I want to run through the main reasons why I think this can be a dangerous idea.

A Roth IRA should not be used as your Stage 1 emergency fund

Before you even consider mixing your emergency fund and your Roth IRA, you need to have some savings built up in a separate savings account to handle your Stage 1 emergency needs. You DO NOT want to be tapping your Roth IRA when your car’s windshield wipers stop working or your child has an unexpected trip to the doctor. You want a simple, regular savings account for those basic needs. Your Roth IRA should only be considered an option for your Stage 2 emergency fund.

The dangerous game of mixing retirement and other savings

From a purely behavioral standpoint, mixing your retirement savings with other savings can be a dangerous game. It’s hard enough to save for something 30-40 years away. When you add in the mentality that maybe that money could actually be used sooner, you run the very real risk of allowing yourself the indulgence of sacrificing your retirement savings to spend on something that could maybe be handled another way. Dipping into your Roth IRA even one time suddenly makes it mentally very accessible and makes it much more likely that you’ll dip into it again. Before you know it, you might not have anything saved in your Roth IRA and you’ll be left wondering what happened to all that money you had such good intentions for.

This may sound a little silly, but it’s important not to underestimate the mental part of building financial security. Habits are powerful things and can be used for our benefit or can quickly derail even the best-laid plans.

It’s much better to cut back in other areas so you can do both

If at all possible, it’s a much better option to put money aside for retirement AND put money aside for your Stage 2 emergency fund. If anything, putting emergency fund money into a Roth IRA is a temporary measure that will eventually need to be corrected. So if you’ll have to do both at some point, why not do it now? Most of us have certain areas where we could cut back our spending. Maybe you can’t cut enough to completely replace the need to combine these savings goals, but any little bit will help. The more you can do now, the more you’ll accustom yourself to saving for both, which is a much better long-term skill to have.

When should you think about it?

With all of that said, if all of the following conditions exist then I think that using your Roth IRA as an emergency fund can be a good idea:

  1. You have a separate Stage 1 emergency fund.
  2. You have more money that you’d like to set aside as the beginning of your Stage 2 emergency fund.
  3. You would not otherwise be able to set aside money in your Roth IRA specifically for retirement.

If those three conditions exist, then I would consider putting your Stage 2 emergency fund money into a Roth IRA. The reasoning is pretty simple. Each year, you’re allowed to contribute a certain amount of money to your Roth IRA. For 2013 that amount is $5,500. Once the year is past (technically once the tax filing deadline is past), you are no longer allowed to make that contribution. And since every year of contributions matter, and the early years matter even more, you should try to take advantage of every opportunity to contribute as much as you can as early as you can. Since your hope is that your Stage 2 emergency fund never has to be touched anyways, putting it into your Roth IRA can be a good way to get your contribution handled while also ensuring that the money is available if you really need it.

How should you do it?

If you do decide to use your Roth IRA for emergency fund money, it’s important to remember that you still need to keep your money safe. Most people think they should put their money in their retirement accounts into the stock market, which is largely true if you’re actually earmarking it for retirement. But this is money you need safe. Pick something like a CD or money market fund that will essentially function like a savings account. If you put it into risky investments, it may not be there when you need it. That violates the entire purpose of an emergency fund.

Finally, as soon as you can start putting money aside in a separate savings account to serve as your true Stage 2 fund. As soon as you can build that to a reasonable level, completely sever the idea in your mind that your Roth IRA money is available if you need it. The sooner you can separate the two, the better off you’ll be.

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32 Comments... Read them below or add one of your own
  • Grayson @ Debt Roundup August 16, 2013

    Great post Matt. I appreciate you talking about my post. Your advice is how I use mine. I only keep a small amount in my Roth as a backup. That is a very last resort kind of thing.

    • Matt @ momanddadmoney August 16, 2013

      Sure Grayson. Thanks for the inspiration. It sounds like you’ve got a good approach to it.

  • Holly Johnson August 16, 2013

    I personally wouldn’t want to use my Roth IRA as an emergency fund…it’s for retirement! But, you never know what kind of curveballs life will throw at you. If something totally unexpected happened where I needed all of my retirement funds, I suppose that it is nice that the money is easy to access.

    • Matt @ momanddadmoney August 16, 2013

      I definitely keep them separate as well. But if yours options are combining them or not contributing to your IRA, I think it can be beneficial to combine them.

  • John S @ Frugal Rules August 16, 2013

    Good balanced post Matt! I can see the value in doing it, though for me it’s more of a behavioral issue and want to keep the two separate. That said, if something completely crazy happens, sure I can access those Roth funds if need be, though I’d really not like to. One important thing to remember though, and I believe you pointed it out, is that gains (if you pull them out before five years of funding) are not tax free if you do not meet the parameters.

    • Matt @ momanddadmoney August 16, 2013

      I only really see it as a last resort. As soon as you can build up a real emergency fund I think you really need to think of your Roth (or any retirement account) as off-limits. Obviously it is there if life really hits you hard, but any reasonable emergencies should be handled with other resources.

  • Andrew August 16, 2013

    I was thinking about post an article about using a Roth IRA to save for a downpayment but haven’t gotten around to it. I am of course on the side that it is okay to “mix” purposes in your accounts. I do not have a specific emergency fund but I do have a large amount of money in CDs which I was hoping to use as a downpayment. If I had no need for the downpayment, I would keep my emergency fund at a minimum. I like how you broke down the emergency fund into “stages” and I answered yes to the “When should you think about it?” questions so in my situation I would do it. As for the behavioral aspect, I have a very high standard for “emergency.” Also, it is my understanding that you cannot take out contributions from your IRA unless you have had the account for five years.

    • Matt @ momanddadmoney August 16, 2013

      I would definitely put saving for retirement ahead of saving for a down payment. In fact, that’s exactly what we’ve done. I don’t really think that mixing your retirement funds with something like saving for a down payment is the same as mixing it with an emergency fund. An e-fund is something you hope you never have to use, while saving for a specific goal like a down payment explicitly means that you’re going to eventually use the money for that goal. So in that sense, you’re using up valuable tax-favored space to save for a short-term goal that doesn’t really utilize those advantages and in the process makes it harder to save for retirement.

      Obviously there are always different ways to get to the same end, but I think the distinction between money you hope to not spend vs. money you definitely will spend is important.

      • Andrew August 17, 2013

        Sorry for going a bit off topic, but it’s been on my mind a lot recently. I don’t feel like I’m using tax-favored space because I’m not taking advantage of the entire IRA contribution limit right now. I make contributions to my IRA monthly and put money aside in a “high yield” (if .84% is high yield) online savings acct to save for a downpayment. As I don’t know the timeline for buying a house, or even if maybe I’ll eventually just rent since I live in a High COL area, I figure I might as well max out my IRA and reduce/ignore putting more the online savings. If I ever need to make a withdrawal, I have the option, though I wouldn’t raid it to buy a house. Another factor is that I have a pension so I don’t feel my IRA is the primary source of retirement income.

        • Matt @ momanddadmoney August 18, 2013

          First of all, I’m glad you’re willing to go on a little bit of a tangent. Hearing how people personally relate to these topics is important.

          I’m a little confused though and maybe I misunderstood to begin with. Are you viewing your IRA money as potentially available for a down payment but hopefully not? Or is that we’re you’re putting the majority of your down payment savings? In any case, as long as you have a plan that accounts for both retirement and buying a house (and whatever other goals you have) along a timeline that works for you, you should be all set.

          And to answer a question from your original comment, you can withdraw direct contributions from your Roth IRA at any time. You do not have to wait 5 years. The 5 year requirement is part of what would make the earnings tax-free, but that also requires you to be 59.5. However, there is a 5 year rule for any amounts that were converted to a Roth IRA. Taxes are wicked fun!

          • Andrew August 18, 2013

            Thanks for the clarification of the 5 year rule…they need to simplify the tax code! As for the IRA use for a down payment, I actually don’t do that but was contemplating it. As I do not use all of the tax advantaged space, I figured why not? I don’t put money into buckets, one for retirement, one for emergencies, etc (you know how for ING now Capital One, you can label each account for a savings purpose, i.e vacation fund, house fund). I view all my money as a whole (I understand some behavioral pitfalls of doing this, but I’m pretty hardcore in scrutinizing the use of my money so it’s not like I’m going to raid my IRA funds to buy myself a luxury car). I think an IRA is just a vehicle to save, albeit one intended for retirement. If I was able to max out that space AND save for a down payment outside of it, that would be preferable, but since I am not using all the tax advantaged space, I think maybe I should.

          • Matt @ momanddadmoney August 20, 2013

            Gotcha. I had definitely misunderstood at first. That makes a lot more sense.

            I’ve actually been thinking myself about moving more towards a system where I view things largely as part of one bucket. I think I need to build up some more assets first though. But if the goal is financial independence, whether early or at normal retirement age, at that point your money will largely be just one bucket from which you take your expenses, so I think that there’s value in doing it when you can. For me now though, I still feel like we need a dedicated emergency fund and specific savings goals.

  • Edward - Entry Level Dilemma August 16, 2013

    I’m not too concerned about mixing purposes in accounts, but I wouldn’t ever put short term savings in the stock market. There’s no guarantee it will still be there when I need it!

    • Matt @ momanddadmoney August 16, 2013

      The biggest risk I see in mixing purposes is failing to view it as temporary. If you really need both, then you need to separate them eventually, and ideally as soon as possible. If you’re really comfortable mixing them, you may not feel an urgency to fix that and you might be putting your goals in jeopardy.

  • DC @ Young Adult Money August 16, 2013

    Great points, Matt. It definitely can be used as a “stage two” emergency fund. If I did ever go this route, I would probably plan on never tapping into the Roth unless I hit some extreme emergency expenses that required my “stage one” fund to be replenished.

    • Matt @ momanddadmoney August 16, 2013

      I would much rather have a separate Stage 2 emergency fund, and do in fact, but it can be a good temporary measure. You don’t want to get in the habit of using your Roth to replenish anything or you’re short-changing your retirement.

  • Done by Forty August 16, 2013

    The opportunity costs inherent with taking out the money would make it a last resort, for me. If things really went south, I’d tap my Roth before losing my house or denying my family medical care. But the years of investment gains lost (because you can’t really put back 2012 or prior deposits) would be potentially huge.

  • Money Beagle August 16, 2013

    This would be one of those situations where I would say it’s an automatic no, and that’s simply because if you leave the option open at all, people will try to justify it, change the definitions, etc. and many will end up making poor decisions.

    • Matt @ momanddadmoney August 16, 2013

      I definitely agree that the behavioral risks are real, and should possibly prevent certain types of people from doing it. But I wouldn’t make it a 100% no. I think that in certain situations it can be reasonable as a temporary measure.

  • E.M. August 16, 2013

    I agree that I would only use it in a very last resort situation. I don’t want to touch money that is specifically for retirement. I have my emergency savings in a separate account and that’s the only purpose for it. I don’t really like having things mixed up too much. Makes it easier to keep track of!

    • Matt @ momanddadmoney August 18, 2013

      My setup is the same as yours and for largely the same reasons. I like having money dedicated for different purposes. Too much overlap and you’re leaving yourself vulnerable.

  • Alexa Mason August 16, 2013

    I don’t think I would want to use my Roth IRA as an emergency fund. I don’t like the idea of taking money out of my retirement. I feel much safer having my emergency fund sitting in an easily accessible savings account.

    • Matt @ momanddadmoney August 18, 2013

      I’m right there with you. I do think it could be useful as a temporary measure though. But they way you’ve done it is definitely the better long-term term approach.

  • Matt @ momanddadmoney August 18, 2013

    What you’ve described is certainly a kind of ideal way to handle this situation. If done this way, then you’ve certainly benefitted yourself by getting money into your IRA that otherwise wouldn’t have been in there. I do think the mental part is something to keep in mind though and possibly a reason to avoid doing it at all.

  • cashRebel August 20, 2013

    Interesting perspective. I think it definitely depends on how likely each person is to save money outside of the Roth IRA. If it’s used as a crutch to start saving and investing, I think it’s ok. I agree that the sooner you can separate the two, the better.

    • Matt @ momanddadmoney August 20, 2013

      Right, I think it can be a useful temporary measure. But you should really separate them as soon as it’s possible to do so.

  • Margaret J. Myrick August 24, 2013

    It is important thing to plan for your retirement by choosing the retirement plan the good fits you either as an employer, employee, or a self-employed individual.

  • Aaron Bullen November 18, 2013

    For me, I would consider opening a new Roth IRA for a portion (50%) of my 6 month emergency fund, completely separate from the one I am actually sticking 15% of my income for retirement in, thereby avoiding the mixed purpose. I just think I could be doing better in terms of ROI then in a savings account. Do you think there is too much risk associated with the switch to where this would be a bad idea?

    • Matt @ momanddadmoney November 18, 2013

      Hey Aaron. I think there are a few different questions here. First, if you’re going to use part of your Roth as an emergency fund then I think creating a separate Roth account could be a good idea, simply so it’s clear what’s what.

      But if you can do it, it would be better to max out your Roth AND put your E-fund money in a regular old savings account.

      Finally, I think it’s important to keep in mind that your emergency fund is meant to be safe money and is not where you should be reaching for better returns. Whether you use a Roth or not, the primary purpose of that money is to be there when you need it. The best return you’re going to get with that as your priority will probably be from an online savings account or a low-penalty CD. Sure the low interest rates are frustrating, but don’t forget what that money is really for.

  • Trevor August 22, 2014

    I am absolutely sold on this idea and for the past two years have been in the process of moving my entire stage 2 emergency fund into my Roth IRA. I really feel like more people should be doing this.

    The way I separate the two is that my contributions are my emergency fund and my earnings are just an added bonus to my retirement. The idea of letting a significant amount of money (6 months expenses) sit there for 40 years and earn half a percent interest is crazy to me. I’d much rather aggressively invest it in index funds and ride the waves. I know that investing your emergency fund in stocks is frowned upon by some but you can compensate by saving a little extra, maybe 8 months expenses. Even if the economy nosedives, you still will have 4-6 months expenses to fall back on.

    Let’s say that you’re 30 and have 30k dollars in your emergency fund. Assuming 1% interest on a savings account and an average of 6% in an index fund, the difference after 35 years is about 190k. This doesn’t even account for the fact that the Roth earnings are tax free. I feel like I’ll be very happy with my decision when I’m 65.

    • Matt Becker August 24, 2014

      It sounds like you may have reached the point where you don’t really need a designated “emergency fund”, which I talk about a little bit here. That’s a great place to be, and I definitely agree that there’s a certain point at which you really don’t need to keep much cash in savings.

      But even if you’re not that far along, there are still arguments for investing your emergency fund (seen here). I get the logic there, but to me it still feels a little bit like that logic that you should invest 100% in stocks just because it’s the highest expected return. While it’s likely to give you the best outcome, the downside is also higher.

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