Using a Roth IRA as Your Emergency Fund

by kristine on February 16, 2011

Should You Use a Roth IRA as Your Emergency Fund?

The original purpose for Roth IRAs was to save for retirement.  They are individual retirement accounts after all.  However, the flexibility of Roth IRAs has opened them up to a whole world of possibilities that don’t exist with other retirement accounts.

Flexible Rules Allow You To Use a Roth IRA as Your Emergency Fund

Roth IRAs are one of the most flexible investment accounts available.  While many of the traditional IRA rules apply – contributions are limited, qualified withdrawals are those taken after age 59 ½, etc. – Roth IRAs enjoy their own rules that make them truly unique from other retirement accounts.

First, your contributions to a Roth IRA can be taken out at any time, for any reason, without paying taxes or penalties.  This is the feature that makes Roth IRAs unique from other retirement accounts.

Because you can get your contributions out tax and penalty free, Roth IRAs can be used for many financial goals, not just for retirement.  You can use Roth IRAs to save for college expenses for yourself or your children, to help pay for your first home, to help cover living expenses if you become unemployed, to help pay for unexpected medical expenses, and much more.

You can also get the earnings out of your Roth IRA penalty free if you meet certain exceptions, so if you withdraw all of your contributions you may still be able to access your Roth IRA before you reach age 59 ½ for certain purposes.

As a result of their flexibility, many people have started using Roth IRAs in lieu of traditional emergency funds.  There are both advantages and disadvantages to using a Roth IRA as your emergency fund:

Advantages of using a Roth IRA as your emergency fund:

 

  • Contributions can be taken out at any time without paying taxes or penalties, so there’s no worry about a big tax bill if you have an emergency and need to tap into your Roth account.
  • You can save for dual financial purposes with a Roth IRA; so if you decide to use your Roth for both retirement and emergency savings and you never need to tap into the account for an emergency, then your retirement nest egg is that much larger
  • You can invest in stocks, mutual funds and other investments, thereby increasing your potential rate of return; since savings and money market rates are so low, this is very appealing to many people
  • Roth IRAs are not as accessible as a savings account, so you’re less likely to tap into your Roth IRA for non-emergencies.

Disadvantages of having your emergency fund in a Roth IRA:

 

  • Not very liquid:  Roth IRAs are typically invested in mutual funds, stocks, bonds and other investments.  You’ll have to sell the investments for cash before you can withdraw the money
  • Market risk: because your Roth IRA funds are usually invested in the market, if you have an emergency when the market is down, you could be forced to sell positions at a loss
  • Not very accessible: it can take up to a week to receive your funds when you request a Roth IRA distribution, so Roths aren’t the best way to save for true emergencies where you need the money right now.
  • Every time you tap into your Roth IRA you’re taking money away from your retirement nest egg.  If this is your only source of retirement funds, this could be a dangerous strategy.

Why You May Not Want to Use a Roth IRA as Your Emergency Fund

So while using a Roth IRA as your emergency fund CAN be done, it’s not necessarily the best strategy.  Your emergency fund should be liquid and accessible so that you can get your money quickly in case you have a true emergency.

The general rule of thumb is that you should have 3-6 months of expenses set aside in an emergency fund.  However, most people will never need that much unless they become unemployed or they have substantial medical expenses that are not covered by insurance.

Therefore, one strategy is to split your emergency fund into two parts – a liquid account that you can access right away for things like unexpected car repairs, and a backup emergency fund to be used for bigger emergencies, like being unemployed for several months.  In this case, using a Roth IRA as your emergency fund might be a good backup strategy, assuming you already have a short-term liquid emergency fund already in place.

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