Could Your Roth IRA Make a Good Emergency Fund?


by


20 January,2014

Not too long ago, an acquaintance came to me, wondering how he could set aside money for a short period of time and still potentially earn a decent return. He mused about the idea of using a Roth IRA for the money, since it’s possible to withdraw your contributions anytime without penalty. I also spoke with someone who is interested in using his Roth IRA as an emergency fund.

While these aren’t my favorite ways to use a Roth IRA, the ideas do have merit. A Roth IRA can be attractive as a short-term savings vehicle, or as an emergency fund.

Potential Gains

Savings yields are awful right now. And with the Federal Reserve likely to keep its benchmark rate low into 2015, that’s not changing anytime soon. It’s depressing to try to build an emergency fund and house it in a savings account. True, the point of an emergency fund isn’t to earn a fabulous return, but it’s still disappointing to realize that you are probably losing out to inflation.

With a Roth IRA, you can put the money in an investment account that offers the potential for higher returns. While you can’t withdraw those earnings without consequence, it can still be a nice way to start building up your nest egg’s value. Plus, the gains you do have are tax-free. You can leave the gains in your account and withdraw the contributions as needed. The gains keep earning (although not as much as if you left your contributions in the account), so you have that aspect of it as well.

For those who just want an emergency fund that also provides the possibility of reasonable returns, the Roth IRA can be a tempting choice. However, it’s important to remember that there is also the possibility of capital loss. Those who use a Roth IRA for an emergency fund often reduce the chances of loss by investing in index funds or ETFs. That way, instead of risking the emergency fund on stock picking prowess, some of the danger is reduced with the help of overall market performance.

Another reason that some like to use the Roth IRA for short-term savings or for emergencies is due to the fact that the money is a little harder to access. It requires an extra step or two, and that forces you to think before you act.

Downsides to Using the Roth IRA as an Emergency Fund

While a Roth IRA does have some merit as part of an emergency fund strategy, or for short-term savings, there are also some limitations to be aware of.

First of all, the amount you can contribute each year is limited to what the IRS sets. For 2014, the most you can contribute to your IRA accounts is $5,500. If you are trying to build an emergency fund, that might not be enough to suite your purposes — especially if you run into problems early on in the process. After two or three years, it can make a difference, but the limits mean you can’t ramp up your efforts without putting some of your money in a taxable investment account or in a savings accounts.

Another consideration is the income limitation. Once you make a certain amount of money, you are no longer allowed to contribute to a Roth IRA. This can diminish the effectiveness of your Roth IRA as a long-term retirement investment. The best time to contribute to a Roth IRA is when you are younger, and you make less. You pay taxes at a lower rate (since contributions are made with after-tax dollars), and you build up your nest egg with an account that allows you tax-free gains. If you are taking money out for emergencies, or to meet short-term goals, you miss out on a lot of those gains, and the ability to get a good start on your nest egg while you are young.

In the end, you need to carefully consider your situation, and the consequences of using your Roth IRA as an emergency fund or for short-term savings. Look at your finances as a whole, and then decide on a course of action that is most likely to help you prepare for the long-term.