Using a Roth IRA as an Emergency Fund – Pros and Cons

Roth IRAs are by far my favorite type of investment holding account available.

I love the idea of setting aside $5,000 in after-tax money in order to never pay taxes on the amount ever again.

There are other perks to using a Roth IRA besides never paying income tax on your nest egg.  One of the most prominent: you can withdraw your contributions at any time, even before retirement.  (This isn’t recommended, of course, but it is possible.)  You won’t pay any penalty or taxes for withdrawing your contributions under normal situations.  You will pay tax and penalties if you withdraw your investment earnings, so never do this.

This unique withdrawal capability has some people counting on their Roth IRAs as an emergency fund.

But is this a wise choice or a fool’s gamble?

Should I Use My Roth IRA as an Emergency Fund?


First, let’s look at the pros and cons of this investing and saving tactic.

Pros of Using a Roth IRA as an Emergency Fund

You might be surprised to find there are some actual positives surrounding the idea of using your Roth as an emergency fund.

The biggest of which is sometimes convincing yourself to go ahead and open the account with some money that is just sitting around as an emergency fund can motivate you to get started with a Roth IRA now rather than later.

If you have to first save up 6 months of living expenses first — which can take a long time for many people — you’ll have to wait that much longer to open your Roth IRA.

Another perk of starting now: you are maximizing how many years you can use a Roth.  You can’t go back in time to fund a Roth IRA from four years ago.  Since you can only contribute $5,000 per year (or $6,000 if you are over age 50) each year, once the time limit for contributions passes for a given year that’s it.  You can never go back to fund a contribution for that year.  If you start now — even by stretching a little bit — you maximize the number of years you will use a Roth.

Looking for more?

Consider if you missed out on opening an account, but never touch your emergency fund.  If you never use your emergency fund there is no reason not to use that money as investment capital for your future retirement.

Cons of Using a Roth IRA as an Emergency Fund


As you might expect there are some significant downsides to using a Roth IRA as an emergency fund.

The largest downside is you may be forced to sell your investments at low or negative returns in order to pay for an emergency that pops up.

If you put $5,000 in today and the market drops 25% in 6 months, you will only have $3,750 (minus trading costs) left to cover your emergencies.  You are putting your rainy day fund at risk.

Secondly, you will need to select ultra conservative investments (see below for more info) in order to try this strategy.

That means your investments will not have the growth you need to reach retirement.  It it much better to keep investment funds separate from saving funds.  The two have different purposes and trying to mix them together in one account can get difficult very quickly.

How to Use a Roth IRA as an Emergency Fund

Roth IRA as emergency savings

Is a Roth IRA a safe enough place for you emergency savings?

If you think you have the financial discipline to try this, here are some steps to take:

Use Ultra Conservative Investments

After you have opened your Roth IRA with a great broker or mutual fund company, you will need to choose investments for your money to go into.  (A common misconception among investors is that “My Roth IRA went down” — your Roth IRA didn’t go down, the investment it holds went down in value.  The IRA is the account that holds all the investment pieces you put in it.)

Since you really cannot afford to lose any of the money invested in your Roth IRA, you’ll want to choose incredibly conservative investments like a money market mutual fund or simply leaving the money as cash inside the account.  You are not required to buy stocks, ETFs, or mutual funds with the money.  It can sit there, earn zero interest, and be invested later.

Related: Great Online Discount Brokers

Start a Real Emergency Fund ASAP

After you elect which investments, if any, to make you will want to start an actual emergency fund inside a normal savings account.

Look at it as borrowing some investing money from yourself out of your emergency fund.  Now that the money is borrowed, start building up your real emergency fund outside of the Roth IRA.  Once your emergency fund is complete you can begin contributing funds back into the Roth IRA and make more aggressive investment choices so reach your retirement goals.

Final Thoughts

Using your Roth IRA as a temporary holder for your emergency fund is an aggressive and risky strategy.

However, if you have decent cash flow coming in every month and can stomach the idea of your emergency fund going down in value right when you need it, then using the funds to open a Roth IRA sooner than you normally could is a decent idea.  Just make sure you protect your investment with very conservative investments (or leave the money as cash in the account), and start rebuilding your emergency fund outside of the Roth as soon as you can.

What do you think of using a Roth IRA as an emergency fund?

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Published or updated October 24, 2012.

Comments

  1. Nice article and you make some compelling arguments. However, and call me old school, but I would discourage the use of a Roth as an emergency fund. I’m fine with the idea of building the emergency fund gradually and saving for retirement (Roth, 401k, etc.) at the same time. I’m not saying your idea is without merit, I just prefer to see people save for retirement, or save for ST needs (including an emergency fund) and keep those funds separate. This method would make it too easy to justify dipping into the Roth. What is a real emergency? The furnace, yes. Something else, maybe not.

    • Yep – I am with you Roger. I think emergency savings is a different deal. Only thing I sometimes advice people to do is to use the Roth IRA as a way to save for a down-payment on a house (first-time) or to cover college expenses in the future. But this is only when all other retirement accounts are funded.

  2. I don’t think it should ever happen. If it’s even a remote possibility then you probably shouldn’t bother opening a Roth IRA at all. To me, those contributions are permanent and if you aren’t willing to commit to that, then you need to re-think your strategy.

  3. I’m with Roger in that I don’t like the idea of using a Roth as your emergency fund. However, if you wanted to invest the money extremely conservatively…specifically in a money market account within your Roth, then you’re getting the tax advantage and there is no risk in losing your much-needed emergency fund.

  4. I think combining your emergency fund with your Roth is a terrible idea. There’s really no need to because you can put it in a money market outside of the Roth, and it keeps from muddying the waters as to what is emergency fund money and what is Roth money.

    I agree with Roger, it makes it too easy to dip into the Roth in an emergency or to pay down debt, and sacrifice part or all of your future to fulfill a present need.

    I wrote an article a while back illustrating this point that may be of interest.

    “Drunken Sailors and 401k’s”
    http://www.cfinancialfreedom.com/CFFwordpress/drunken-sailors-and-401ks/

  5. Jenna, Adaptu Community Manager says:

    I’m not sure I could do this. However, it’s nice to know the option is available.

  6. I agree with most here – bad idea jeans. I’m all for setting up a Roth IRA but using it for an emergency fund is a slippery slope. First, it’s just not a good idea to mix long-term and short-term goals in an account specifically designed for the long-term. Your Roth should be growing as aggressively as you can handle. Having ultra-conservative investments runs counter to the purpose of why the account exists (unless that is truly your risk profile, but that’s a different story). Second, dipping into your Roth just once can set a bad precedent. Once you’ve convinced yourself it’s OK to tap into those funds, there’s little stopping you from making it a bad habit.

    If you’ve gone to the trouble of opening a Roth IRA, opening an online savings account or a taxable account specifically for your Emergency Fund goal is not much more work. And lastly, make sure you have adequate homeowners/condo/car/property insurance that cover the specific risks that you face. Adequate insurance is usually the first line of defense against many emergencies and can prevent you from having to dip into your savings in the first place.

  7. I agree that if you lack the self control to move your emergency funds into a Roth vehicle that could allow you to withdraw without penalty, by all means, don’t do it.

    But if you’re a responsible adult investor that’s carefully considered all the alternatives, developed a comprehensive retirement plan and wants to take advantage of the tax-advantaged status of the Roth IRA, by all means, go for it! Each year those with lack of self control can pay a bit to the Federal Government while more responsible investors get to keep reinvesting those profits.

    Long live responsible investors!

  8. I am against this idea for the reason you mentioned: you might have to sell at a loss. You investments should be for the long term, not the short term. If you are investing for the short term, you need to be very conservative with your choices. Since money grows in a Roth tax free, why not get the biggest capital gains you can since they won’t be taxed when you take the money out in 30+ years?

    I’d just put my emergency fund money in online savings accounts and some more in a taxable account that invests in short term bonds and GNMA bonds.

  9. One other key point: a $5,000 Roth IRA invested for 30 years at an 8% return will turn into $54,679. That would mean $49,679 in capital gains, or at the 15% capital rate, a tax savings of $7,452 in taxes you won’t have to pay (but would otherwise pay if not sheltered by the Roth). With compound interest, the tax savings in a Roth relative to the original investment are huge, and a big cost if you withdraw early from the Roth.

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