Using a Roth IRA for your emergency fund

Using a Roth IRA with your emergency fund can have many benefits. This is especially true if you are not currently contributing to your Roth IRA. However, it’s not for everyone. Read on to find out if it’s the right solution for you, and what benefits you can realize by using this strategy.

The basics

What is a Roth IRA

A Roth IRA is a type of IRA that allows you to contribute post tax dollars, and then invest that money tax-free. If you receive dividends or sell stocks, while the money resides in the Roth IRA then you will not get hit with capital gains tax and the money can grow much faster than it would in a taxable account.

The max amount that can be contributed, per year, is $6,000 per individual and $12,000 for a married couple. If you are over 50, then you are allowed to contribute an additional $1,000 per year.

In 2021, if you are single and have a modified adjusted gross income over $140,000 then you are not able to use a Roth IRA. For married couples the value is $208,000. In addition, the amount that can be added to the Roth IRA starts to get phased out at $125,000 for single filers and $198,000 for married filers.

If you didn’t contribute to a Roth IRA for the previous year, then you can still put money in up until April 15th, of the next year, and still add to the Roth for the current year’s contribution as well.

What is an emergency fund

This is a buffer fund that typically contains 3-6 months expenses to handle unplanned life event, such as medical bills, unemployment and surprise repairs.

Not sure how much you need for your emergency fund? We have an emergency fund calculator that can help you get that number.

Outside of unplanned events, an emergency fund can be a great way to increase your confidence and willingness to take risks, because you are not as worried about running out of money. It might empower you to try for a new job or even start your own business, because you know that there is a safety net in place, should you fail.

Benefits of using a Roth IRA for your emergency fund

Make money with your emergency fund

The big advantage of using a Roth IRA for your emergency fund is that it is tax-free. Meaning that you can make more money when investing, than you might in a taxable account.

The main reason to invest the money is that 3-6 months expenses is a large amount of money and it will lose its value each year due to inflation. By investing the money you can beat inflation and actually have an asset that makes money for you each year.

Emergency fund investing is a different style of investing, because you want to make sure you have the money available to you when you need it. For example, if a recession hits, and you are 100% invested in stocks, then you might lose 50% of the value of your emergency fund right when you are laid off. If you’re interested in learning more, we have a guide on how to invest your emergency money funds to make the most of that money.

Fully contribute to your Roth IRA for the current tax year

Each year the amount that can be contributed to a Roth IRA is capped. Another way to use this strategy is to put the money in the Roth IRA, for your emergency fund, so you are meeting the yearly distribution. Then, when you have more money down the line, fund your emergency fund into savings and keep the Roth IRA money for retirement.

The saver’s credit

Investing in a Roth IRA may also allow you to receive a saver’s credit for your taxes. The savers credit is a tax cut for low to moderate-income taxpayers of up to $1,000 for individuals and $2,000 for married couples. The credit can reduce your taxes, but will not actually give you a tax refund, if you do not owe any taxes. To be eligible you must:

  • Be 18 or older
  • Not be in school full-time
  • Not claimed as a dependent on someone elses tax return
  • Have made tax contributions to a 401k, 403(b), 457 plan, Simple IRA or SEP IRA
  • Have an AGI (adjusted gross income) below the limit.
    • $32,500 for single filers
    • $48,750 for heads of household
    • $65,000 for married couples

Reasons not to use a Roth IRA with your emergency fund

Your Roth IRA is already being used for something else

If you are actively saving the max IRA contribution for your retirement, then this is not a good strategy to use. It works best when the person is not contributing to the Roth IRA at all and is instead using a vehicle, like a 401k, for retirement. The big issue is that the contributions are capped by year, so your retirement money potential will be reduced if the money goes towards the emergency fund instead.

You will need the money immediately

Withdrawals can typically take 3 business days to clear, if you need the money immediately this might not be ideal. A workaround to this issue would be to have a portion of your emergency fund in savings, so you could access it immediately, while you wait for the additional money to clear.

You will need to frequently withdraw from the fund

For people who use their emergency fund often, this may not be a good technique. The reason being is that it’s hard to get the money back into the Roth IRA. Doing frequent withdraws will cause you to hit the 12-month limit of redepositing funds and your money will be trapped outside the tax-free safety of the Roth IRA.

Accessing your Roth IRA money

Avoiding a Roth IRA withdrawal penalty

To avoid a Roth IRA withdrawal penalty, you can only withdraw what you contributed. This means if you put $30,000 in the Roth IRA, and made $60,000 investing for a that you could only withdraw up to $30,000 without getting hit by a 10% penalty.

If you redeposit the money you took within 60 days, you can also avoid the withdrawal penalty as well.

Putting money back into your Roth IRA

Once you have used the money, you have 60 days to return the money. You can only do this once per calendar year.

Final thoughts

If you are not currently contributing to your Roth IRA, then it can be a great option to enhance your emergency fund. Just be careful to know the rules about how much you can contribute and how to withdraw money without getting hit by penalties.