An emergency fund is a necessary part of any successful financial situation. Unfortunately, with interest rates so low, savers are getting the short end of the stick. While the purpose of an emergency fund isn’t to provide fabulous returns, the yields offered on even “high-yield” savings accounts are disappointing.
In order to stave off some of that disappointment, some investors are starting to use the Roth IRA as an emergency fund.
Withdraw Your Roth IRA Contributions at Any Time
Wait a minute: Isn’t the Roth IRA supposed to be for retirement? What about penalties? The Roth IRA has different rules, depending on whether you are withdrawing contributions or earnings. First, understand the difference between these two types of money in your Roth IRA:
- Contributions: This is the money you put into your account. For 2012, the contribution limit is $5,000, or $6,000 if you are 50 or older. This assumes that you meet the income requirements, and aren’t subject to a phase out.
- Earnings: This is your return. It’s the money that you receive in investment gains.
If you opened a Roth IRA last year, and contributed $5,000, and it’s all invested in SPY, which tracks the S&P 500, you might have seen a 5.45 percent return on your money (before subtracting applicable costs and fees). In the simplest terms, not accounting for compounding, fees, dividends, and other factors, your earnings are $272.50. That means your account total is $5,272.50.
Under Roth IRA rules (check IRS Publication 590 for more information), you can withdraw up to $5,000 without paying taxes on it, and without paying a penalty. Once you dip into your earnings – that $272.50 – the story changes. You can withdraw what you have contributed at anytime, and for any reason. So, if you have contributed $5,000 a year faithfully for the last three years, you now have $15,000 available to you from your Roth IRA.
Why a Roth IRA Makes an Attractive Emergency Fund
Imagine that same $5,000 from last year was held in a high-yield savings account. We’ll keep it simple for this calculation as well. If you are luck, you can get a yield of 1.01 percent, earning you $50.50 for the year. Just letting money sit in a Roth IRA and using that as an emergency fund means that the money sitting there brings you $222 extra for that one year. And, of course, the more money you have in your account, the more you have the potential to earn while you save for retirement.
Using a Roth IRA as an emergency fund is attractive because, while the money is in the account, it has the potential to work harder on your behalf. (That changes, of course, if the investments in your Roth IRA lose value.) You don’t have to worry about penalties and taxes as long as you avoid dipping into your earnings. It’s considered something of a win-win: When you let the money grow, and keep making contributions, you help your retirement, but when you need the money now, you can withdraw your contributions.
Downsides to Using Your Roth IRA as an Emergency Fund
Before you decide to use your Roth IRA as an emergency fund, it’s important to consider the drawbacks:
- It takes time to get your money: You might need access to the emergency fund money immediately. Requesting a withdrawal, though, can take time. You can shorten the time by calling your broker and requesting an ACH transfer. This can take three to four business days. If you mail a request, and ask for a check, the process can take more than two weeks. If you need the money today or tomorrow, you might not get it fast enough.
- Opportunity cost: Once you remove that principal, it is no longer working on your behalf. You lose out on possible gains. Many people also fail to replace the principal at a later time. That further compounds the problem of missed opportunity. Even if you do “repay” yourself, there is no retrieving the time your money wasn’t earning compounding interest. You might put your retirement at risk.
For some, though, the Roth IRA as an emergency fund offers benefits beyond these drawbacks. If you have other tax-advantaged retirement accounts helping you build your nest egg, using a Roth IRA can be a viable way to boost the returns on the money in your emergency fund.
Miranda is a freelance contributor to several investing and personal finance web sites. She also writes for her own blog, Planting Money Seeds.