The standard advice on emergency savings is that you want to keep yours in an FDIC-insured deposit account, protected from the stock market’s vagaries. For most people, that means keeping your emergency savings separate from your retirement savings.
But here’s a relatively unusual strategy that can come in handy: using a Roth IRA account — generally used for retirement savings — as a backup for your emergency savings.
Why a Roth?
Because of the Roth’s special rules — you can always withdraw your Roth contributions tax- and penalty-free — using a Roth IRA as an extra emergency fund might make sense for some people.
“Invest with an eye on emergencies, rather than retirement, until you've built up your emergency funds.”
Think of it as a backup to your main emergency account. You choose how to invest in your Roth, so you can park your “emergency fund” contributions in cash or other lower-risk investments. That is, you invest with an eye on emergencies, rather than retirement, until you've built up your emergency funds.
» How much is enough for your emergency fund? Check out our calculator.
Once you’ve saved enough for emergencies, you can begin to invest future contributions based on your risk tolerance and long-term retirement outlook, says David G. Metzger, CFP, founder of Onyx Wealth Management in Chicago.
Why shouldn’t you use a traditional IRA for an emergency fund? Because traditional IRAs are funded with pre-tax dollars, so withdrawing contributions before retirement can trigger a serious tax bill, along with penalties.
Also note that the withdrawal rules are different for Roth conversions and for Roth 401(k)s. This article focuses on contributions to Roth IRAs.
» Check out our top picks for best Roth IRA providers.
Is this strategy for you?
Now, let’s say you have three or six months’ worth of emergency savings, but your goal is to save up a year’s worth or more — yet you have a competing goal of adding more to your retirement savings. A Roth could potentially help you pursue both.
“I would rather my clients have cash sitting in a Roth IRA earmarked for an emergency than having them forgo Roth IRA contributions and leave cash sitting in a savings account unused,” says Tony Madsen, CFP, president of NewLeaf Financial Guidance in Redwood Falls, Minnesota.
But, he adds, “I wouldn't do this with funds we may need in the next six months.” Withdrawing money from a Roth is more complex than withdrawing from a bank account, so having some funds parked at your bank is your best first line of defense against emergency expenses.
» Not sure how a Roth IRA works? Read our guide.
Another reason to consider stashing some emergency funds in a Roth is that you might become ineligible as your income rises. People in that situation who ignore a Roth “will have missed out on the opportunity to contribute while their income was lower and they were busy building up an emergency fund,” Metzger says.
“Other candidates for this strategy are risk-averse folks who keep an overly large sum of money stashed in a bank account.”
With a Roth IRA, there’s an annual contribution limit for everyone — for 2018, it’s $5,500, plus an extra $1,000 if you’re age 50+ — but there are income limitations, too.
Other candidates for this strategy are risk-averse folks who keep an overly large sum of money stashed in a bank account. Knowing that Roth contributions can be withdrawn without penalty or taxes may help encourage them to invest, says Hui-chin Chen, a CFP with Pavlov Financial Planning in Arlington, Virginia.
“Some people may have a low risk tolerance and want to keep a lot of cash, even when it's not completely necessary,” she says. “Simply knowing that they can draw some funds from a Roth IRA when they really need it without paying taxes makes them more willing to invest.”
That said, for people who don’t have enough saved for emergencies, Chen says she’s opposed to the use of a Roth as a backup vehicle. “A true emergency fund should be liquid and predictable,” she says.
Keep in mind, too, that putting emergency savings into a Roth entails some complexity, including choosing investments and maintaining a record of your contributions. If you prefer keeping your financial life simple, stick with a bank account for your emergency savings — though be sure to find a high-yield savings account to ensure you’re getting a competitive rate of return.
Tips for using a Roth as a backup emergency fund
If you’ve decided this is the right strategy for you, here are some best practices:
Focus on emergencies. Only use a Roth IRA for a backup emergency stash if you’ll withdraw the money for exactly that: emergencies. That is, only tap this money if your primary emergency savings fund is depleted, and you really have no other option. Check out our story on options to consider when your main emergency savings account runs out.
Stick with safer investments. As you’re building your backup emergency account, invest in cash or similarly low-risk investments, rather than the stock market, until you have your account built up. If you do end up needing the money, you don’t want to be forced to sell stocks if the market is down and your shares have dropped in value.
Don’t expect immediate access to your funds. Pulling money out of your Roth IRA may take time, depending on your investments and your broker — as much as three to five days, says Michael Schupak, CFP, founder of Schupak Financial Advisors, in Jersey City, New Jersey.
Keep good records. You should keep track of exactly how much you’ve contributed over the years to be sure you don’t pull out more than you’ve put in. If you accidentally withdraw investment earnings, you may owe taxes and possibly a penalty (though there are exceptions). Also, after making a withdrawal, you may have to file the IRS’ Form 8606 with your tax return. See this IRS page for more information.
Best-case scenario? You don’t need to touch that money until retirement. “If you never have to withdraw your contributions, you’ve managed to get a head start on your retirement savings,” Schupak says.