A recent Pew Charitable Trusts study released in March came to the scary conclusion that roughly one-third of Americans would have trouble coming up with $2,000 in the event of an emergency. Clearly, this is a problem. Try as one might, emergencies are bound to happen from time to time. Some of them may not have an impact on your finances, but many emergencies will. With that in mind, let’s talk for a moment about the ultimate emergency fund, the Roth IRA.
So what makes the Roth IRA such a great emergency fund? Quite simply, it has the capacity to “check all the boxes” an emergency fund should have, and then some.
Distributions from most retirement accounts are subject to a 10% early distribution penalty if funds are accessed prior to 59 ½. There are several exceptions to this penalty, but none of them are for financial hardship due to an emergency of some kind, with the possible exception of medical expenses. Thus, retirement accounts, in general, don’t make great emergency funds.
But the Roth IRA isn’t like most retirement accounts. Contributions to a Roth IRA can be withdrawn at any time, for any reason, 100% tax and penalty free. It’s true the Roth IRA should generally be the last money you turn to in an emergency, it’s growing potentially tax free after all, but when it’s all you have, what choice is there?
It’s worth noting that those with higher incomes may be phased out of making contributions to a Roth IRA, and distributions of Roth IRA conversions may not receive the same tax and penalty free treatment (that’s for another day) but if you’re at the income level where you can no longer make a Roth IRA contribution, you should be able to find other ways to set up an emergency fund.
Safety of Your Principal
What good is an emergency fund if the money you put aside is no longer there when you need it? That’s why, as a general rule of thumb, emergency funds should be kept in cash or other very safe investments.
Can you hold cash in a Roth IRA? Sure. Many banks and credit unions allow Roth IRA savings (or similar accounts) to be established. You can also open up a brokerage account and simply leave your contributions un-invested and in the standard money-market account.
And if none of those options appeal to you, there’s also the myRA account. The myRA account was created by the Obama Administration several years ago. It’s a special type of Roth IRA that allows for small contributions. It only has one investment option, but that option works well for emergency funds. It’s a liquid investment option that earns a modest rate of interest and guarantees principal.
With any luck, you’ll eventually be able to save enough money elsewhere that you’ll no longer need your Roth IRA as an emergency savings account. When that happens, you can easily transition the money in your Roth IRA to long-term investments to meet your retirement planning needs.
Now of course, the Roth-IRA-as-an-emergency-fund strategy only works if you have the financial means to make Roth IRA contributions. If you know that you can access those funds whenever you need, it may give you a great comfort level to make those contributions. Plus, for those with more modest income, the federal government may actually pay you to make the contribution in the form of the Saver's Credit! A tax credit from Uncle Sam for building your emergency savings fund? That's just one more reason why the Roth IRA may make the ultimate raindy day fund for those just starting out.