Saving

Is Using a Roth IRA As an Emergency Fund a Good Idea?

retirement savings

Remember the Roth IRA Movement day two months ago? Along with a couple hundred other personal finance writers, I tried to twist your arm into opening a Roth IRA, the most flexible retirement account in America.

I explained that the Roth IRA lets you contribute after-tax dollars and withdraw them tax-free during retirement and that everyone with an income under $125,000 (single) or $183,000 (joint) can contribute to one.

Oh, and I also mentioned that a Roth IRA can double as an emergency fund.

You could hear the tsk-tsk noises far and wide. Encouraging people to raid their retirement accounts for a garden-variety emergency? Investing your emergency money in the stock market? Irresponsible!

Well, I stand by my advice. For many people, but not everybody, a Roth IRA can make a great backup emergency fund, or even your entire emergency fund. Would it work for you? Read on.

But first, let’s excuse a couple of people who should NOT use their Roth IRA as an emergency fund:

  • If you make too much to contribute to a Roth IRA, forget it.
  • If you make enough to contribute $5,000 in retirement savings to your Roth and still have plenty left over to put in an emergency savings account, do so.

Robots vs. humans

If you’ve ever gotten into credit card debt, you know that there’s an endless debate about how to repay it: start with the highest-interest debt, which results in the lowest overall interest payments? Or use Dave Ramsey’s “debt snowball method” and start with the smallest balance, which keeps you motivated by serving up small wins near the beginning of the process?

Using a Roth IRA as an emergency fund raises the same issues: mathematically, there’s no question that it makes sense. But once you add real people with their human foibles into the equation, it gets murkier.

The reason we’re talking about this at all is that the Roth IRA has a unique feature among retirement accounts: you can withdraw contributions tax-free and without penalties at any time. If I put $50 into my Roth IRA, I can withdraw that $50 at any time in the future, even if I’m nowhere near retirement. If I earn interest (or dividends, or capital gains) on the money, I can’t withdraw that interest without a penalty, only the amount I contributed.

With this in mind, let’s walk through a simple example of someone tapping their RothIRA for an emergency.

Let’s say I just got my first job, and I can save $4,000 per year outside my 401(k). I put $4,000 in my Roth IRA. Then I have a $1,000 emergency. I’m left with $3,000 in my Roth.

Here’s where the fingers start wagging. As Bankrate.com put it, “When you withdraw money from your Roth, you lose the benefit of having the money grow tax-free over many years.”

This is true, but irrelevant, because you also lose the benefit of tax-free growth if you never put the money in the Roth in the first place. Think of it this way: every dollar you save is more valuable in a Roth (because it grows tax-free) than in a regular savings account. Anytime you fail to use your whole $5,000 of annual Roth contributions, you’re paying unnecessary taxes.

The humans strike back

That’s all fine for the robots who never misbehave financially. The humans would like to point out that taking money out of your retirement accounts before retirement is a bad habit and if you’re doing it for every two-bit emergency, you’re going to wind up in retirement with $125 in your Roth IRA.

“I don’t think that we can make an argument against a wise utilization of an account simply because of fear of exceptions,” says Tim Maurer, a Certified Financial Planner with the Financial Consulate near Baltimore.

Maurer doesn’t advise using a Roth IRA as your only emergency fund, but for a young saver, considering the Roth IRA as a backup emergency fund can actually reinforce good behavior. “They can be slightly more aggressive with their retirement savings,” he says, “recognizing that if they absolutely had to go get a little bit, they could.”

In other words, knowing that you could raid that Roth IRA without penalty if you really had to means you can be aggressive about filling it up, even if it means taking longer to build that legendary “six months of expenses” emergency fund.

Another notch in the “pro” column: typically, when you take a withdrawal from your Roth IRA, even if you’re withdrawing contributions without penalty, your bank or brokerage will give you a stern warning, something like, “Are you SURE you want to do this? I’m going to have to tell the IRS about it, you know.” It’s enough to make you think hard about whether you’re spending on a real emergency. Regular savings accounts aren’t so naggy.

Stocking up on savings

Now, what about that last objection? A young person’s Roth IRA is typically filled with stock market investments. You wouldn’t invest your emergency fund in stocks, because it might be a fraction of its former self in the midst of an emergency. (Especially since emergencies like unemployment or loss of health insurance tend to coincide with recessions, which tend to coincide with stock market plunges.)

Well, there’s no law that says you have to invest your Roth IRA in stocks. You can build an emergency fund inside your Roth IRA using a short-term bond fund or CDs with minimal withdrawal penalty. You can even put a plain-old online savings account inside your Roth IRA.

No, none of these investments offers much in the way of interest. But they pay even less interest outside your Roth, because outside a Roth, the interest is taxable. Once you’ve built up a solid emergency fund, inside or outside your Roth, then you can add risky investments to your portfolio.

Basically, here’s what I’m saying: if you’re responsible and a good saver but are not yet in a position to save more than $5,000 outside your 401(k), you should take full advantage of Uncle Sam’s tax-free box called the Roth IRA. If you’re irresponsible and a bad saver, you’re going to have trouble building an emergency fund and retirement savings no matter what box you use.

Tim Maurer disagrees, and he’s a professional advisor, so I’m going to give him the last word and then let you weigh in in the comments.

“Habits that you start early have a tendency to be more difficult to break,” says Maurer. “If you gave someone that 100% freedom—you’re young, you’ve only got $5,000 in discretionary dollars, let’s just hope you don’t have any emergencies—and just throw it all in the Roth…it may be more difficult for them at any point in time to say, oh, well, now let’s set aside five, ten,  or $15,000 to purely have for emergencies.”

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.