In an ideal world, you’d always have enough money to put toward all of your goals without making any sacrifices or compromises.
But that’s not usually the reality. Most of the time you’re working with a limited amount of money, trying to decide whether you should be putting it toward this goal or that goal.
For example, you may know that building an emergency fund is an important part of creating financial security. You may also know that it’s important to start saving for retirement early. And you may want to do both, but you simply might not have the money to do so right now.
If that’s the situation you’re in, a Roth IRA could be your saving grace. Because a Roth IRA is flexible enough to be used as an emergency fund right now while also preserving the opportunity to grow into tax-free income in retirement.
Here’s how it works.
Why the Roth IRA Can Function as an Emergency Fund
While the Roth IRA is designed to be a long-term retirement account, it has two qualities that allow it to function as an emergency fund.
1. Your Money Is Accessible
Unlike other retirement accounts, money inside a Roth IRA is not locked away until retirement. In fact, you’re allowed to withdraw up to the amount you’ve contributed to your Roth IRA at any time, and for any reason, without tax or penalty.
For example, let’s say that you’ve contributed $5,000 to your Roth IRA over the years and your account balance has grown to $6,000. With most retirement accounts, the entire $6,000 balance would be off-limits until retirement age unless you were willing to pay taxes and penalties, or you were willing to take out a 401(k) loan.
But with a Roth IRA, you would be allowed to withdraw up to $5,000 without any financial consequences, no matter how old you are, when you made your contributions, or what you were withdrawing the money for.
In other words, most of the money in your Roth IRA is accessible if you need it.
Now, it’s worth mentioning that the earnings in your Roth IRA would be subject to both taxes AND a 10% penalty if you withdraw them before age 59 1/2. So in our example above, if you tried to withdraw the last $1,000 from your account, you would have to pay a $100 penalty in addition to taxes. (There are some exceptions to the penalty.)
So your Roth IRA isn’t 100% accessible, but it’s accessible enough to consider using for short-term savings like an emergency fund.
2. You Can Invest Conservatively
Most of the time you’ll be investing fairly aggressively within a retirement account like a Roth IRA. Given that you’re investing over a multi-decade time period, you’ll likely have some significant amount of your money in the stock market to take advantage of the long-term growth it provides.
On the other hand, your emergency fund is money that you may need at any moment, and should therefore be invested conservatively, if at all. A regular savings account is typically the best place to keep it, since it comes with the guarantee that your money will be there if you need it.
The truth is that you can invest within a Roth IRA in pretty much the exact same way as you would invest within a savings account. Money market mutual funds typically provide the same assurance that your account balance won’t decrease, and some banks – such as Ally – even offer IRAs that pay interest at the same rate as their regular savings accounts.
In other words, not only is your Roth IRA accessible, but you can invest it in such a way that ensures your money will be there when you need it.
When Should You Use Your Roth IRA as an Emergency Fund?
Given that money within a Roth IRA is both accessible and can be invested just as conservatively as a savings account, it clearly CAN be used to hold your emergency fund. But that doesn’t mean that it should be used that way.
In fact, for most people it’s probably a good idea to keep your retirement savings and your emergency fund separate. They serve very different purposes, and you’ll be better off saving for them separately.
But there’s a scenario in which putting your emergency fund inside your Roth IRA makes sense, and it looks like this:
- You already have money set aside for routine irregular expenses like car repairs, gifts, and home maintenance.
- You don’t have a larger emergency fund that could handle bigger needs, like a period of unemployment or an unexpected car replacement.
- You can’t afford to both build that emergency fund AND contribute to your retirement accounts at the same time.
No. 1 is important because even if you can, you don’t want to be dipping into your Roth IRA for routine expenses. Money for those things should be kept in a checking or savings account.
Beyond that, you really should be building a bigger emergency fund as a foundation of your financial security But you also don’t want to miss out on the opportunity to use valuable tax-advantaged retirement space before it’s gone. You’re only allowed to contribute up to $5,500 per year to your IRA ($6,500 if you’re 50+), and if you don’t do it by April 15 of the following year, then the opportunity is lost.
So rather than miss out on that opportunity, and rather than ignoring the need for an emergency fund, you could do the following:
- Contribute to your Roth IRA now.
- Invest it conservatively, either in something like a money market fund or a savings account equivalent.
- If an emergency does come up, you can withdraw up to the amount you’ve contributed without consequence.
- In the meantime, you can work on building a true emergency fund outside of your Roth IRA. Once you’ve done that, you can re-purpose your Roth IRA money for retirement savings and invest it more aggressively.
If you do it right, you get the security of having an emergency fund while at the same time preserving the opportunity to get decades of tax-free growth for retirement.
It’s the best of both worlds.
Take Advantage of Your Roth IRA
Ideally, you’d be able to BOTH build your emergency fund in a regular savings account AND save for retirement. If you have the money to do that, you should absolutely keep those things separate.
But that’s not always possible, and when it isn’t, it’s nice to have an option that allows you to handle your immediate need now without completely sacrificing the long-term tax benefits that a Roth IRA offers.
Matt Becker, CFP® is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.