You Can Use a Roth IRA as an Emergency Fund. Here's How
Building an emergency fund is essential so you don't run into financial trouble if you lose your job or unexpected expense crops up. But keeping your emergency fund in a traditional savings account may not be the best solution. To make your money work harder for you, a Roth IRA could be a better option. Despite the fact that a Roth IRA is a retirement savings account, it can also double as an emergency fund. But if you opt to use your Roth IRA for emergency savings, there are rules you must follow to avoid penalties and tax obligations. You may want to work with a financial advisor to ensure you don't miss out on any rules and that you repay the funds per the rules of your IRA.
What Is a Roth IRA?
Roth IRAs are tax-advantaged retirement savings accounts you can use to build a nest egg for the future. Because Roth IRAs are funded with post-tax dollars, you won't receive a current-year tax deduction on your contributions like you would with a traditional Roth or 401(k) account. But Roth IRAs still offer some valuable tax benefits, including tax-free investment growth and no taxes on distributions in retirement.
Like most other retirement accounts, Roth IRAs are subject to contribution limits set by the IRS. For 2023, these limits are $6,500 if you're under 50 or $7,500 if you're 50 or older. The total amount you can contribute starts to phase out as your income increases, but a Roth IRA could still be a smart place to stash your emergency savings.
What to Know About Using a Roth IRA for Emergency Savings
The IRS has some fairly strict rules about withdrawing retirement savings before age 59 ½. For instance, with a traditional 401(k) or IRA, early withdrawals are generally subject to ordinary income taxes and tax penalties. That's because these types of accounts are funded with pre-tax dollars.
The IRS does make certain exceptions related to early withdrawals from traditional IRAs, though. If you withdraw funds without penalty to pay for a first home (up to $10,000) or qualified higher education expenses, for example. But you'll still need to pay taxes on any funds you withdraw.
Roth IRAs work slightly differently because they're funded with post-tax dollars. Since you've already paid taxes on contributions, the IRS will allow you to withdraw the portion of the account you've contributed at any time without penalty as long as your Roth IRA has been open for five years. Withdrawals of contributions are also tax-free.
However, if you withdraw any investment gains before age 59 ½, those withdrawals will likely be subject to taxes and penalties. For instance, if you contributed $20,000 to your Roth and your investments have grown to $25,000, you could only withdraw up to $20,000 without taxes or penalties.
Despite this rule, a Roth IRA could still be a good home for your emergency savings. That's because the returns you earn from a traditional savings account may be lower than what you'd gain when you invest. For context, the FDIC has capped rates for savings accounts at just 0.30%. While a high-yield savings account may offer a significantly higher APY of up to 4.00%, it's unlikely it would exceed the potential gains you could get by investing. The S&P 500, for example, earned an average annual return of around 11.88% from 1957 to the end of 2021.
Traditional Savings Account vs. Roth IRA
Now let's consider how these returns might apply to a $20,000 emergency fund balance if you left it in savings vs. a Roth IRA for five, seven and ten years. For the purposes of this example, we'll assume a 0.30% APY for your savings and a 9.00% annual return for your Roth.
5 Years 7 Years 10 Years Traditional Savings Account $20,302 $20,424 $20,608 Roth IRA $30,772 $36,560 $47,347
As you can see, there's a significant difference in potential growth between a savings account vs. a Roth IRA. Of course, this example assumes you aren't touching your original $20,000 contribution for years, which might not be the case if you're using it as an emergency fund. Even so, the compound interest you could earn from putting your money into a Roth IRA may be worth it.
The Bottom Line
Assuming you abide by the rules the IRS has established regarding Roth IRA withdrawals, this type of account could be a good home for your emergency fund. A Roth IRA offers higher growth potential than a traditional savings account, though growth isn't guaranteed. Investment performance will depend upon when you invest, what you invest in and other factors. Despite this, if you're fairly risk-averse, a Roth IRA may be a good option for emergency savings.
Tips for Retirement Planning
Planning for retirement and trying to make sure you have enough assets when you need to use those funds from time to time can be hard. A financial advisor can help you find the right investments to make sure you reach your financial goals and ensure you're ready for retirement. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
If you're trying to predict what your retirement funds will look like as you consider using some of those funds, try using SmartAsset's free retirement calculator to see how much you'll need in your retirement years.
Photo credit: ©iStock.com/szefei, ©iStock.com/LeoPatrizi, ©iStock.com/LeoPatrizi
The post How to Use a Roth IRA as an Emergency Fund appeared first on SmartAsset Blog.