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:
- You have a separate Stage 1 emergency fund.
- You have more money that you’d like to set aside as the beginning of your Stage 2 emergency fund.
- 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.