Why the Roth IRA Is the Ultimate Savings Account

Why the Roth IRA Is the Ultimate Savings Account

Most people think about the Roth IRA as a retirement account, which makes sense given that that’s what it was originally designed for.

But the Roth IRA has some unique features that make it much more flexible than other retirement accounts. Really, a Roth IRA is resourceful enough to be used effectively for just about any financial goal, from short-term emergency savings to long-term retirement savings.

With that in mind, this post will explain exactly why Roth IRAs are the ultimate savings account, including five specific financial goals they’re especially good for.

Quick note: If you make too much to contribute to a Roth IRA directly, you may still be able to contribute using either the Backdoor Roth IRA or the Mega Backdoor Roth IRA.

The Roth IRA’s unique flexibility

There’s a key feature to the Roth IRA that makes it much more flexible than other retirement accounts.

Most people know the basics of how a Roth IRA works:

  1. Contributions are made after-tax (they are not deductible)
  2. Your money grows tax-free inside the account
  3. You can withdraw your money tax-free in retirement

What many people don’t know is that you’re allowed to withdraw up to the amount you’ve contributed to your Roth IRA at any time, and for any reason, without tax or penalty.

Let’s say that you’ve contributed $20,000 to your Roth IRA over the years and that your investment return has grown that balance to $25,000. You’d be allowed to withdraw up to $20,000 from your Roth IRA at any time, no matter how old you are and what you’re using the money for, without facing any taxes or penalties. That money is yours to use as you please.

The other $5,000 is considered earnings, and in most cases you’d face both taxes and a 10% penalty for withdrawing it before the age of 59.5. Though we’ll talk about some exceptions to that in just a bit.

But it’s the ability to access your contributions, along with a few other special features, that allows you to use your Roth IRA for a number of financial goals that other retirement accounts can’t be used for.

So now let’s talk about all the different ways you can use your Roth IRA.

Quick note: Direct contributions to a Roth IRA are available immediately for any reason, but money that’s converted to a Roth IRA is subject to a 5 year waiting period before you can withdraw it without tax or penalty.

1. Retirement savings

The obvious and primary use of a Roth IRA is for retirement savings. The fact that your money grows tax-free and can be withdrawn tax-free is pretty powerful.

The truth is that the benefit of tax-free withdrawals is often overstated, and in many cases a Traditional IRA is actually a better bet.

Still, a Roth IRA is a great way to save for retirement and can also offer some tax-diversity if you’re already contributing a significant amount of money to a 401(k) or other tax-deferred investment account.

2. College savings

Most people think about 529 plans when they think of college savings, and those are generally the best option if you’re 100% sure you want the money to be used on higher education.

But Roth IRAs have three special features that make them an excellent college savings account:

  1. You can withdraw your contributions at any time and for any reason, including college expenses.
  2. Any earnings you withdraw from your Roth IRA that are used for higher education expenses are exempt from the normal 10% early withdrawal penalty (assuming your Roth IRA has been open for at least 5 years). Those earnings will be taxed, but avoiding that 10% penalty is a big cost-saver.
  3. If you don’t end up needing the money for college, you can simply keep it in the Roth IRA and use it for retirement.

If you’re not yet fully on track for retirement, or if you simply want to maintain a little flexibility while also saving for college in a tax-efficient way, a Roth IRA is a great choice.

3. Emergency fund

Yes, a Roth IRA can be a reasonable place to put your emergency savings.

First, since you can access your contributions at any time, putting money into a Roth IRA keeps it available in case of emergency.

Second, you can keep some or all of your Roth IRA in a money market fund, which is basically the same as a savings account. That way you know the money will be there if you need it, which is key for emergency savings.

Third, by putting it in your Roth IRA, you’re able to take advantage of that valuable tax-advantaged space before it’s gone.

Ideally, you’d be able to keep your emergency fund in a regular savings account and use your Roth IRA for long-term investments. But if the alternative is not contributing to an IRA at all, it’s probably a smart move to make the contribution.

If an emergency comes up and you need the money, it will be there. If not, your money can grow tax-free for decades.

And eventually, once you build up your traditional savings, you can move that Roth IRA money into longer-term investments so it can grow even faster.

4. Buying a house

If you’re a first-time home buyer, which the IRS defines as not having owned a home in the past two years, you can withdraw up to $10,000 of your Roth IRA earnings, both tax-free AND penalty-free, to put towards a house.

This is in addition to the ability to withdraw up to the amount you’ve contributed, meaning that a potentially significant amount of your Roth IRA money could be put towards a home purchase without any taxes or penalties being taken out.

Now, there are a few pitfalls to watch out for:

  1. The $10,000 exception is a cumulative lifetime limit.
  2. You can only qualify for the exception if you have had your Roth IRA open for at least 5 years.
  3. If you’re relying on your Roth IRA money for retirement, withdrawing it to buy a house may not be the best idea.

This is a strategy that should be used with caution, but it’s yet another way that your Roth IRA is available to you.

5. Savings for your child

If your child has earned income, you should consider opening a Roth IRA for him or her.

It would have to be a custodial account, meaning that you would be able to manage the account but that the money would actually be your child’s. Most major investment companies offer these though, so that shouldn’t be difficult to do (I personally use Vanguard).

And doing this has a number of big benefits:

  1. You can explore the concepts of saving and investing together, helping your child build these skills early on.
  2. By starting early, your child can get a huge head start towards financial independence.
  3. And again, because Roth IRAs are so flexible, this is money your child will be able to use for any number of goals as he or she gets older.

You can learn more about whether your child is eligible and how to open an account here: Why and How to Open a Roth IRA for Your Child.

Roth IRA: The Ultimate Savings Account

Given how accessible the money within a Roth IRA is, it’s hard to think of a reason not to contribute.

The worst case scenario is that you contribute today, have a major unexpected expense tomorrow, and you no longer have the money in your checking and savings accounts to pay for it. In which case you can simply withdraw your Roth IRA contributions to make up the difference.

And the best case scenario is that your money grows tax-free for years, after which you can withdraw it tax-free for retirement or withdraw it with minimal cost for major goals like college or a house.

So, if you haven’t yet maxed out your IRA contributions for the year, now is a good time to consider contributing money to a Roth IRA before that tax-advantaged space is gone forever.

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  • Syed April 4, 2017

    Great overview Matt. I didn’t know you could avoid the penalty if used for college expenses that’s good to know.

    I especially like the Roth because like you said you can withdraw contributions at any time so you have some liquid funds that you can use in a pinch. I’d rather not use it if I don’t have to, but it’s nice to know that I can.

    Another reason I tell people to contribute to a Roth IRA when you can is that you may not always be able to. The income limit for single filers is $133,000, which would exclude many successful working professionals. So contribute while you can!

    • Matt Becker April 4, 2017

      That’s a good point! It could be smart to save some tax-free money now if you won’t be able to later on, especially if that means you’re moving to a higher tax bracket.

  • Anna April 5, 2017

    This may be a stupid question, but how do you start a Roth IRA, where do I go? Is it online so I go to my credit union?

  • I love the Roth IRA. The fact that they let you withdraw your contributions first and not pro-rate it between contributions and earnings is seriously so awesome. That’s not the case even a Roth 401k.
    I use it as part of my emergency fund like you suggest. We don’t really know when we’ll retire, so this provides some flexibility for us to withdraw money tax-free as well as opposed to keeping everything in our 401k.

    • Matt Becker April 6, 2017

      Good idea!

    • RB February 27, 2019

      I totally agree. We use part of our Roth for emergencies also!! I have a 403B, but I don’t want all of money going only into it.

  • We have a similar account type in Canada called the Tax Free Savings Account, it is a great way to save and invest in a registered account without losing the flexibility.

  • eric June 9, 2017

    Super article on Roth IRA’s. We love them for our younger and middle aged clients as well. I did not know a bout taking withdrawals from a Roth for a home purchase, so thanks for the tip! We also use Vanguard funds for older people in low risk bond portfolios because of the low fee structure. Good luck in 2017!

  • SHAWN July 4, 2017

    Quick
    question/verification. As I understand it,if I start a Roth for my 16 year old it will not count against her on the FAFSA?

    • Matt Becker July 7, 2017

      Good question Shawn. Money inside a Roth IRA will not count against her. But money withdrawn from a Roth IRA will count as income for FAFSA purposes, even if it’s not counted as income for tax purposes. FAFSA has a 2-year lookback though, so you can factor that into your planning.

  • Mia April 3, 2018

    Is Roth IRA the same as ROTH 401k? I believe my husband has a 401k AND Roth 401k with his job

  • James Brown October 29, 2018

    Hi Matt,

    What I have not been able to understand, is why not just leave a portion of your Roth to be your emergency fund? Why build it up inside the Roth, to then build one up outside of a Roth and then take the Roth into longer term investments? Why not just come up with what you want your efund to be in the roth, always leave it there and then build for the long term? I’m just wondering if there is something I am not getting or missing.

    • Matt Becker October 29, 2018

      Good question James. The main reason is that you don’t want to have to dip into tax-advantaged retirement money if you don’t have to, and having a separate emergency fund outside of your Roth IRA helps prevent that. By taking the money out of savings and leaving your Roth IRA untouched, that Roth IRA money can grow tax-free for longer and provide more retirement income.

  • Sheila T January 26, 2019

    Hi Matt,
    A popular online bank told me that my initial contribution to open the Roth savings account had no limit and all subsequent contributions were subject to annual limits. I really doubt this but don’t know how to verify. Can you weigh in please?

    • Matt Becker January 28, 2019

      Unfortunately that’s not true. With the exception of rollovers or conversions, all contributions are subject to the annual limits.

  • Dudley March 1, 2019

    Hello Matt,
    My wife and I are retired and our only income is from SS and traditional IRA monthly distributions. Can we contribute to a Roth IRA using cash funds such as from a savings account, cash from a home sale, or cash in excess of RMD from our traditional IRA?

  • Joshua Ory March 22, 2019

    Hi Matt,
    Great write up! I have been doing a fair amount of research on this exact topic. I have gotten a lot of conflicting information from tax professionals and other online articles. I recently contacted vanguard and they basically told me exactly what you mentioned in your article.

    Question for you….Can you reference the IRS documentation where this is mentioned and spelled out? I found the IRS documentation to be vague or maybe I was looking in the wrong location.

    Thanks in advance for your time!

    • Kimberly April 6, 2019

      I have the same question. I looked on the IRS website, and it seems that you can take out your contributions in the amount your put in prior to the end date of the current tax year. My understanding is if I put in $6,000 today, I can withdraw $6,000 prior to the tax deadline of April 2020 without penalty. I’ve included the document I found on the IRS website. Skip down to P28 where it talks about contributions.

      https://www.irs.gov/pub/irs-pdf/p590b.pdf

      • Matt Becker April 26, 2019

        I’m sorry it’s taken me so long to respond Kimberly. What you’re referring to is the ability to undue a contribution, which would generally be done after finding out after the fact that your income made you ineligible to contribute. In that case you would file for a “return of excess contributions” and both your contribution and the earnings on that contribution would be returned to you. The contribution amount would not be taxed but the earnings would.

        That’s different, however, from simply withdrawing money. You can refer to IRC Section 408A for the details, but the bottom line is that withdrawals are treated first as withdrawals of contributions, and those withdrawals are not counted as taxable income.

  • Ron Irwin December 6, 2019

    Thanks for the article, Matt. I just turned 59.5 and as fate would have it I immediately ran into a cash liquidity problem involving paying off an auto loan. I withdrew the full $7,000 from my IRA which included both contributions and tax free earnings on the account. I know I won’t have any tax or penalty issues due to my age. But as I mentioned, the liquidity problem is only temporary and I’ll have access to $6,000 by the end of the year.

    My question is, since the Roth account is over 5 years old, can I put the $6,000 back into the account in late December and withdraw the contribution and new earnings at a later point, tax free, should I need it? Or, in other words, do I have to wait another 5 years before tapping the new earnings, tax free? If it’s the former, then it seems to me that the IRA, post-59.5, becomes a tax free savings account with literally no limitations.

    Note to those in their 50’s: open a Roth IRA immediately even if it’s with a nominal $100 deposit because once your account is 5 years old you can tap all of the earnings, tax free, after age 59.5.

    My second question is, once I retire from my job in a few years and I’m in a super low tax bracket, does it make sense to withdraw from my 401k at the low tax rates and park the money in the Roth IRA (where future earnings will be tax free) even if I don’t immediately need those 401k funds? Are there disadvantages to this strategy?

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