It's no secret that stashing away funds in a tax-advantaged retirement account is a savvy financial move. However, the stringent rules attached to these accounts can often make it challenging if you need to access your savings in an emergency.
Because of this, many people might feel apprehensive about fully utilizing retirement savings options like IRAs or 401(k) plans. Balancing the act of saving for retirement while keeping an emergency fund for life's unpredictable moments can seem like a monthly tightrope walk.
However, Roth IRAs offer a lesser-known feature that might be the answer to this dilemma. Read on to learn more about how to set up and use your Roth IRA as an emergency fund.
WHAT IS A ROTH IRA?
A Roth IRA (Individual Retirement Account) allows individuals to save and invest money for their retirement on an after-tax basis, which means that you make contributions with income that you have already paid taxes on. The significant advantage is that qualified withdrawals during retirement are tax-free, including contributions and any earnings on the investments.
Also, unlike traditional IRAs, Roth IRAs do not require account holders to take required minimum distributions (RMDs) during their lifetime, providing more flexibility in retirement planning. Additionally, there are income limits for contributing to a Roth IRA, which vary depending on your tax filing status.
The IRS permits you to contribute $7,000 annually to a Roth IRA for 2024 and 2025. For married couples, the combined contribution can reach as high as $14,000, as each partner is eligible to contribute $7,000. Additionally, individuals 50 years old or above can make an extra contribution of $1,000, known as a catch-up contribution.
Bear in mind that these contributions phase out for individuals and married couples filing jointly at higher income levels.
WHEN SHOULD I ACCESS FUNDS IN MY ROTH IRA?
Let’s talk about leveraging this account in case of unexpected expenses. Unlike traditional retirement accounts, you can withdraw the contributions (not earnings) you’ve made into your Roth account at any time. You can also withdraw your contributions AND earnings when the account has been open for five years and you have reached the age of 59½.
The beauty of using your Roth IRA as a place to store emergency funds is that it allows you to maximize your yearly Roth contributions while also creating a reserve for serious personal contingencies.
However, refrain from using these funds for minor setbacks like car repairs or small medical expenses—a separate savings account should cover these. Reserve your post-tax account as a last resort for more substantial emergencies such as prolonged unemployment or severe illness.
There are several alternatives you should consider before tapping your Roth IRA emergency fund. Here they are, listed in the order you should consider accessing them in the event of an emergency:
Ideal Order for Accessing Emergency Funds
Once liquid funds from your Roth IRA are exhausted, you might consider whether to sell investments in your Roth account, take out a low-interest personal loan, borrow against funds held in a work 401(k), or opt for premature withdrawal of invested funds in a regular or Roth IRA (which will incur penalties).
PROS AND CONS OF USING A ROTH IRA FOR EMERGENCIES
Now let’s explore the relative advantages and disadvantages of using Roth IRA investments as part of your emergency fund:
PROS OF USING A ROTH IRA AS AN EMERGENCY FUND
Benefits of storing emergency funds in a Roth IRA include:
- Tax-free contributions withdrawals: You can withdraw your contributions (not earnings) at any time without taxes or penalties.
- Maximize your retirement contributions: Contributing to a Roth IRA ensures you don't miss the annual contribution limit, which cannot be carried over to future years.
- Tax-free growth: Funds left in an IRA account grow tax-free, unlike a regular savings account where earnings are taxed annually.
- Earning potential: Even in liquid, low-risk investments, Roth IRA funds earn more interest than a traditional savings account.
- Dual Purpose: Combines the benefits of retirement savings with emergency fund accessibility, allowing you to meet two financial goals at once.
CONS OF USING A ROTH IRA AS AN EMERGENCY FUND
Potential disadvantages of storing emergency funds in a Roth IRA include:
- Limits potential retirement saving growth: Funds kept liquid for emergencies may earn less than those invested in stocks or bonds.
- Risk of dipping into retirement savings: Frequent withdrawals can deplete your retirement nest egg, making it harder to achieve long-term goals.
- Contribution limits: Roth IRA contributions are capped annually, so using funds for emergencies in the same year you contributed can prevent you from maxing out your contributions.
- Not ideal for minor emergencies: Funds kept in a Roth IRA are better suited for major emergencies, as smaller, frequent withdrawals can disrupt your account's growth.
- Lost Opportunity for Compounding: All contributions withdrawn reduce the potential for tax-free compounding over time, which can significantly impact long-term savings.
HOW TO SET UP A ROTH IRA EMERGENCY FUND
Emergencies don't knock on the door before entering, which makes having a safety net crucial. While your post-tax retirement account offers flexibility, it's essential to use it judiciously. Here’s how you can set it up with emergencies in mind:
1. LIMIT DISTRIBUTIONS TO CONTRIBUTIONS
One of the cardinal rules is to limit your withdrawals to the amount you've deposited and avoid withdrawing any earnings. Remember that your account statement won't categorize funds into "contributions" and "earnings." Therefore, it's vital to keep track and ensure you never withdraw more than you’ve put in.
2. KEEP THE EMERGENCY PORTION LIQUID
Consider keeping the portion of your contributions designated as your emergency fund liquid. Place this amount in an account where you can quickly convert it to cash without losing value, rather than investing it in stocks, bonds, or mutual funds.
3. AVOID INVESTING THE EMERGENCY PORTION
Since you might need to use this money during a financial crisis (e.g., a job loss), it’s critical not to have it invested. In an investment vehicle, the value could go down, forcing you to sell at a loss just when you need the funds.
4. MOVE CONTRIBUTIONS TO HIGHER-EARNING INVESTMENTS
As your emergency fund within the account grows, it’s wise to gradually shift some of the contributions to higher-earning investments. Remember, the goal is not to keep all your contributions in cash indefinitely.
5. BALANCE AND EVOLVE
Depending on how quickly you can save, this process might span a few months or even years. The key is to balance emergency readiness and maximize your account’s potential.
By following these steps, you can effectively set up your post-tax individual retirement account as an emergency fund while prioritizing long-term financial growth and security.
RETIREMENT FUNDS AND EMERGENCY SAVINGS
Having an emergency fund is crucial. It’s the financial airbag that deploys when life turns you upside down. Saving for retirement is equally important. The ideal scenario is to have separate funds for both purposes.
Utilizing a post-tax retirement account as an emergency fund should be a last resort. It’s vital to focus on the primary purpose of this type of account, which is to ensure a financially secure retirement.
Here’s why: Dipping into higher-interest retirement accounts to fund emergency expenses means you are missing out on the benefits of years of compounded interest, while money kept in a regular savings account earns much less interest, and hence earnings grow slower.
Let’s look at how these very different rates of returns might apply to a $25,000 emergency fund if kept in savings for five, 10, and 15 years, compared with a Roth IRA, assuming a 0.25 APY for savings and a 7.00% annual return on the Roth.
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BENEFITS OF OPENING A ROTH IRA
Remember, your Roth IRA account isn’t just a retirement vehicle or an emergency backup—it’s a powerhouse of financial benefits:
- Tax-Free Growth: As your investments grow, you don’t have to worry about taxes eroding your earnings.
- No Mandatory Distributions: Unlike some retirement accounts, there are no required minimum distributions at a certain age.
- Flexibility: The ability to withdraw contributions without penalties adds flexibility.
- Legacy Planning: You can pass these accounts on to beneficiaries with tax benefits.
SECURING YOUR FINANCIAL FUTURE
While you can use a Roth IRA as an emergency fund, it's essential to tread carefully to avoid undermining your long-term retirement goals. Click below to learn more about the value you’ll get from opening a Roth IRA at Wasatch Peaks Credit Union.
