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
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.
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.