This post goes against 90% of conventional personal finance advice. The purpose or publishing this post is to start a discussion, so please comment if you have a chance. I’m not saying I’m right or wrong, but it’s a discussion worth having.
The general rule of asset location is to let retirement accounts be for investing for retirement only. However, one benefit to investing in a Roth IRA, is that withdrawals of your contributions are tax free.
For example, if you had contributed $5,000 and your account has grown to $6,000, you may withdrawal up to $5,000 penalty free. Remember, Roth IRA contributions are made with after-tax dollars.
Since you can withdrawal cash contributions penalty free from a Roth IRA, is it OK to use your Roth IRA as an emergency fund? Personally, I think this is a option worth looking at for some people.
Before I dive deeper in this post, I first want to talk about asset allocation. If you’re contemplating using your Roth IRA as an emergency fund, then it’s important to invest like you would in an emergency fund outside of a Roth IRA. Which means, your Roth IRA would be invested in very conservative assets such as a money market mutual fund.
Who Would Want to Use A Roth IRA as an Emergency Fund?
For anyone whose personal financial plan’s #1 goal is flexibility. Generally, this is entrepreneurs, freelancers, someone who might want to change careers, etc… In other words, if you think your situation calls for having more then a three month emergency fund, holding a portion of your emergency fund in a Roth IRA is an option worth looking at.
Advantages to Using a Roth IRA as an Emergency Fund
A Roth IRA is a use it or loose it investment. Each year, you can only invest $5,000. You can’t go back and contribute for lost years. The #1 advantage to investing in a Roth IRA for your emergency fund is you end up contributing for a greater number of years.
Disadvantages to Using Roth IRA as an Emergency Fund
- More investment options outside of a Roth IRA. With interest rates so low, some of the better short-term investments right now are high-yield checking and savings accounts, which are not available inside of a Roth IRA.
- Laws can change, making your contributions taxable upon withdrawal.
Two-Tier Emergency Fund
If you think you need more then three months worth of living expenses in an emergency fund, one option I would look into is to create a two-tier emergency fund.
In the first tier, you would have three months worth of living expenses in a high-yield checking or savings account.
For the second tier, you contribute to your Roth IRA any amount over three months worth of living expenses.
Example – The Entrepreneur
Lets say you’re thinking about making a career change soon. One option you have looked into is starting your own business.
You would feel comfortable quitting your job and going on your own after you have 12-months worth of living expenses.
Therefore, you first save three months worth of living expenses in a high-yield savings/checking account. After you have three months worth of expenses, you then contribute 9 more months of expenses into your Roth IRA.
The obvious advantage here is that if your business can become profitable inside three months, you never touch your Roth IRA. Down the road, once your business stabilizes, you can even switch the 9-months worth of living expenses inside of your Roth IRA, to a higher-yielding investment, such as a Target Retirement Fund.
The disadvantage is that if you blow through your three months of expenses, you have to withdrawal from your Roth IRA for living expenses. There are no penalties for withdrawing contributions. However, once you withdraw, that money is out and can’t be made up.
It’s no secret that life is very unpredictable right now for every member of Gen Y. 37% of Gen Y are underemployed right now! It doesn’t look like it’s getting better anytime soon.
Another thing that scares me is that the 60% of people who are getting laid off are using their 401Ks for their emergency fund. Unfortunately, after taxes and penalties, they receive about 65% of their balance.
With the economy the way it is, using your Roth IRA as an emergency fund is looking like a better option each day.