Roth as Emergency Fund?
January 30, 2012 1:25 PM Subscribe
What is the viability of using Roth as an Emergency Fund?
According to the IRS and explained by various sites (e.g. fivecentnickel.com), an investor can withdraw contributions (not earnings) from a Roth IRA without penalty at any time. Besides the hit on retirement, this seems like an obvious alternative to keeping the 6 month Emergency Fund in case of a job loss. I currently have 3 3-month laddered CDs as my Emergency Fund, obviously not earning anything. My family's employment situation is about as stable as you can get (i.e. government jobs), so I doubt that we'd ever need to tap it anyway. Wouldn't it be better to invest the money in the CDs into mutual funds and count on the Roth IRAs my wife and I have as our Emergency Fund if and when we need it? I'm not talking about using it for car repairs or trips, but only for severe hardships such as sickness or job loss. What's the downside?
According to the IRS and explained by various sites (e.g. fivecentnickel.com), an investor can withdraw contributions (not earnings) from a Roth IRA without penalty at any time. Besides the hit on retirement, this seems like an obvious alternative to keeping the 6 month Emergency Fund in case of a job loss. I currently have 3 3-month laddered CDs as my Emergency Fund, obviously not earning anything. My family's employment situation is about as stable as you can get (i.e. government jobs), so I doubt that we'd ever need to tap it anyway. Wouldn't it be better to invest the money in the CDs into mutual funds and count on the Roth IRAs my wife and I have as our Emergency Fund if and when we need it? I'm not talking about using it for car repairs or trips, but only for severe hardships such as sickness or job loss. What's the downside?
There's no reason you need a Roth IRA to own mutual funds. If you feel that your mutual fund selection is sufficiently safe to have value when you need to use your emergency fund, you can always own the funds in a taxable account.
The downside to the Roth IRA as an emergency fund is not the withdrawing of funds, it's the putting back in of funds. As far as I understand the situation, Roth contributions can not be made retroactively. So, if you have to tap your Roth IRA for $5,000 in March and aren't able to repay it until May (after the Tax Day deadline for previous year contributions), you will effectively lose a year of contributions to your Roth IRA. This may or may not be of concern to you, but it is the cost of using a Roth IRA as an emergency fund.
posted by saeculorum at 1:34 PM on January 30, 2012
The downside to the Roth IRA as an emergency fund is not the withdrawing of funds, it's the putting back in of funds. As far as I understand the situation, Roth contributions can not be made retroactively. So, if you have to tap your Roth IRA for $5,000 in March and aren't able to repay it until May (after the Tax Day deadline for previous year contributions), you will effectively lose a year of contributions to your Roth IRA. This may or may not be of concern to you, but it is the cost of using a Roth IRA as an emergency fund.
posted by saeculorum at 1:34 PM on January 30, 2012
It's a good idea, but probably doesn't net you as much as you'd like.
Part of what makes the fund "emergency" is that it's mostly liquid (and safe). You can cash out your CDs in short order without much suffering. If you put the money in a Roth IRA, in what are you going to invest? CDs / bonds? In which case you're simply avoiding taxes on a trivial amount of growth. Stocks / etc.? Hmm, let's say you have a stock bubble burst the week before you get sick and get laid off. Getting the stocks out as cash will involve a significant capital loss.
Having said that, some chunk of our family's emergency funds are in a Roth IRA. It's only a tiny tax saving, but it's a tax saving nonetheless.
posted by introp at 1:34 PM on January 30, 2012
Part of what makes the fund "emergency" is that it's mostly liquid (and safe). You can cash out your CDs in short order without much suffering. If you put the money in a Roth IRA, in what are you going to invest? CDs / bonds? In which case you're simply avoiding taxes on a trivial amount of growth. Stocks / etc.? Hmm, let's say you have a stock bubble burst the week before you get sick and get laid off. Getting the stocks out as cash will involve a significant capital loss.
Having said that, some chunk of our family's emergency funds are in a Roth IRA. It's only a tiny tax saving, but it's a tax saving nonetheless.
posted by introp at 1:34 PM on January 30, 2012
I find it a good secondary e-fund. The downside is that whatever you have it invested in could be underwater when you have the emergency, so you'd take a huge loss on some or all of it. For example if a stock market decline and massive unemployment happened at the same time, as recently happened... but still, taking a loss on some investments, even a significant one, might be preferable to other sources of emergency funding. Feels good having it there man.
posted by kindall at 1:40 PM on January 30, 2012 [1 favorite]
posted by kindall at 1:40 PM on January 30, 2012 [1 favorite]
If you're not currently maxing out your IRA contribution, I'd say go for it--as you correctly note, you can always take the money out.
But it sounds like you are maxing out your contribution (at least that's how I read it), in which case there are two reasons I wouldn't do it:
(1) introp has a good point... would you start making safer investments in your IRA? If so, you're not really taking full advantage of the tax-sheltered nature of the IRA. If not, you're really just asking whether you need an emergency fund at all.
(2) once you take the money out, you can't put it back in. Let's say at age 50 you need to dip into the Roth--all of a sudden you're sacrificing many more years of tax-free growth (remember, there are no required minimum distributions with a Roth, so you could have waited until age 75 to start taking that money out). And money in your retirement account is pretty strongly protected from creditors--if you had to do a short sale, or got hit with some large lawsuit for a car accident, you might rather have more money in your Roth, as opposed to less money in your Roth and some mutual funds on the side.
posted by _Silky_ at 2:32 PM on January 30, 2012
But it sounds like you are maxing out your contribution (at least that's how I read it), in which case there are two reasons I wouldn't do it:
(1) introp has a good point... would you start making safer investments in your IRA? If so, you're not really taking full advantage of the tax-sheltered nature of the IRA. If not, you're really just asking whether you need an emergency fund at all.
(2) once you take the money out, you can't put it back in. Let's say at age 50 you need to dip into the Roth--all of a sudden you're sacrificing many more years of tax-free growth (remember, there are no required minimum distributions with a Roth, so you could have waited until age 75 to start taking that money out). And money in your retirement account is pretty strongly protected from creditors--if you had to do a short sale, or got hit with some large lawsuit for a car accident, you might rather have more money in your Roth, as opposed to less money in your Roth and some mutual funds on the side.
posted by _Silky_ at 2:32 PM on January 30, 2012
Best answer: Wouldn't it be better to invest the money in the CDs into mutual funds and count on the Roth IRAs my wife and I have as our Emergency Fund if and when we need it?
So if I'm reading this right, this is your current situation:
Emergency Fund: 6 months of expenses in taxable CDs, for emergencies
Roth IRA: Some amount of money, presumably in mutual funds or similar, for retirement
And this is the new scenario you are asking about:
New Investments: Old 6 months worth of expenses, now invested in mutual funds
Roth IRA: Same amount of money, now used for both retirement savings, and if necessary emergencies
What's the downside?
Disregarding the Roth IRA implications for a moment, overall you are moving more of your assets from a safe investment (CDs) to a riskier investment (mutual funds). That sounds like a change you are comfortable with but it could result in points where your assets are worth less than they would have been if you would have kept the safe investments, and to the extreme that could mean you have less than you need for an emergency.
For the Roth IRA specifically, your main risk is that you'll lose out on whatever amount of money you would have made by keeping it in your Roth IRA rather than withdrawing it. So if you pull out $10,000 from your Roth IRA after a job loss, that's $10,000 less that you get tax-free returns on going forward. It might also be $10,000 plus all of the future returns less retirement money when you retire, depending on if you make up for that loss in other retirement accounts once you get back on your feet financially after the emergency. To offset this, you could probably just save more for retirement than you otherwise would have, by maxing out other retirement options or by having a taxable retirement investment account. So if your goal is to save say 15% of your income now, you might bump it to 20% to make up for possible future situations when you have to pull some out of your Roth IRA and reduce your retirement savings to a lower effective savings rate.
Overall I would still suggest having some amount of cash savings for emergencies, but I would definitely plan on using your Roth IRA as an emergency fund of last resort, because realistically there are a lot of possible situations where the financially smart move would be to take some money out of your Roth IRA when faced with no other options.
posted by burnmp3s at 2:34 PM on January 30, 2012 [1 favorite]
So if I'm reading this right, this is your current situation:
Emergency Fund: 6 months of expenses in taxable CDs, for emergencies
Roth IRA: Some amount of money, presumably in mutual funds or similar, for retirement
And this is the new scenario you are asking about:
New Investments: Old 6 months worth of expenses, now invested in mutual funds
Roth IRA: Same amount of money, now used for both retirement savings, and if necessary emergencies
What's the downside?
Disregarding the Roth IRA implications for a moment, overall you are moving more of your assets from a safe investment (CDs) to a riskier investment (mutual funds). That sounds like a change you are comfortable with but it could result in points where your assets are worth less than they would have been if you would have kept the safe investments, and to the extreme that could mean you have less than you need for an emergency.
For the Roth IRA specifically, your main risk is that you'll lose out on whatever amount of money you would have made by keeping it in your Roth IRA rather than withdrawing it. So if you pull out $10,000 from your Roth IRA after a job loss, that's $10,000 less that you get tax-free returns on going forward. It might also be $10,000 plus all of the future returns less retirement money when you retire, depending on if you make up for that loss in other retirement accounts once you get back on your feet financially after the emergency. To offset this, you could probably just save more for retirement than you otherwise would have, by maxing out other retirement options or by having a taxable retirement investment account. So if your goal is to save say 15% of your income now, you might bump it to 20% to make up for possible future situations when you have to pull some out of your Roth IRA and reduce your retirement savings to a lower effective savings rate.
Overall I would still suggest having some amount of cash savings for emergencies, but I would definitely plan on using your Roth IRA as an emergency fund of last resort, because realistically there are a lot of possible situations where the financially smart move would be to take some money out of your Roth IRA when faced with no other options.
posted by burnmp3s at 2:34 PM on January 30, 2012 [1 favorite]
I've seen some quotes on the Bogleheads forum along the lines that it's easier to lose money chasing returns than in regular market fluctuations.
How much extra money would you make - even compounded - by moving your emergency fund to something riskier? How much worry would that cause you if you needed it at a time when your riskier investment had lost value?
posted by kristi at 10:12 AM on February 1, 2012
How much extra money would you make - even compounded - by moving your emergency fund to something riskier? How much worry would that cause you if you needed it at a time when your riskier investment had lost value?
posted by kristi at 10:12 AM on February 1, 2012
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posted by Snarl Furillo at 1:31 PM on January 30, 2012 [1 favorite]