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.

Quick note: Do you want real answers to your personal questions about saving, investing, and other financial issues? Click here to learn how to get them.

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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0 Comments... Be the first to comment
  • 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.

  • 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

    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.

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