The majority of financial planners generally suggest that an essential financial life goal is to maintain enough money in an emergency savings fund to cover at least 3-6 months of necessary expenses. As long as you meet the income limits (or can fund a backdoor Roth without tax issues), one option to consider for your emergency fund is a Roth IRA.
Here are 3 reasons why using a Roth IRA as a portion of your emergency fund may make sense for you:
Unlike other tax-advantaged retirement accounts like a 401(k) and a traditional IRA, early (before age 59 ½) withdrawals of contributions to a Roth IRA are not subject to taxes or penalties. Early withdrawals of earnings may be subject to taxes and penalties, but the contributions come out first.
As an example, if you contribute $6,000 to a Roth IRA and that contribution grows to $10,000, you can withdraw the $6,000 at any time and for any purpose without tax or penalty but not the $4,000 of earnings. (Note that any money you convert to a Roth IRA has a 5 year waiting period before it can be withdrawn tax and penalty-free.)
The main benefit of a Roth IRA is they offer flexibility when it comes to accessing your original contributions. Because Roth IRA contributions are made with after-tax dollars, these contributions can be taken out at any time without tax or penalty. This creates an opportunity to use a Roth IRA as a supplemental source of college funding or any other non-retirement-related financial goal. Tax-free withdrawal of any earnings growth applies if your account has been opened for at least 5 years and distributions occur after age 59 1/2.
More important than protecting your money from creditors, probate, or even the IRS might be protecting it from yourself. Have you ever felt the temptation to raid your emergency savings for a non-emergency? Because of the benefits of keeping your funds saved in the IRA, you will probably be much less likely to spend your Roth IRA on non-essential items than if that money was in a regular account. It also doesn’t hurt that you have to fill out a form for each withdrawal. Those not-so-gentle nudges from Uncle Sam help you think twice about accessing your Roth IRA funds.
Perhaps the biggest advantage of using Roth IRAs as a supplement for emergency savings is the ability to accomplish multiple goals at the same time. By contributing your emergency savings to a Roth IRA, you can build your emergency fund without missing the annual Roth IRA contribution limits (currently $6000 per year in 2020 if you are under 50). One last thing to keep in mind is that you’ll still want to put your Roth IRA money in safe, liquid assets like a bank deposit account or money market fund if it’s the core part of your emergency fund. A general guideline is to at least have a minimum of 3 months’ worth of living expenses in your core emergency fund before using a Roth IRA hybrid strategy to invest for long-term goals while having the flexibility to access your original contributions if needed. Once you’ve accumulated enough liquid savings somewhere else, you can then invest it more aggressively for retirement.