How to Use Your Roth IRA as an Emergency Fund

Ever feel like you don’t have enough money to save for emergencies and also save for retirement? Keeping the money in your bank account makes it easily accessible if you suddenly need a pile of cash to fix your car, cover unexpected medical bills or deal with unemployment. Putting money in a retirement account, on the other hand, comes with rules that can make it difficult to get your hands on your cash should you suddenly need it. These strictures are one reason people can feel understandably reluctant to put too much in a retirement account like an IRA or 401(k), even though we know a comfortable future depends on it. 

Good news: An often-overlooked feature of the Roth IRA could solve your problem. Because contributions to a Roth are made with money on which you've already paid taxes, IRS rules allow you to withdraw that money at any time without penalty.

By contrast, contributions to traditional IRAs are generally made with pre-tax income. You don't pay tax on that money until you withdraw it at 59½ or older, but if you do decide you need to withdraw it before that age, you pay both income tax on your withdrawal and a 10% penalty.  

With a Roth, only your Roth’s investment earnings must remain in the account until you’re 59½ in order to avoid paying a 10% penalty. There are limitations on how much you can earn to qualify for a Roth, but if you do qualify, your Roth can give you the safety of knowing that, if you really need it, you have penalty-free access to these savings. Your Roth account can double as a second emergency savings account. 

How much can you save per year? Subject to income limits, in 2019 a Roth IRA allows you to save as much as $6,000 per year (the 2018 limit is $5,500 ) and still have access to these retirement savings in the event of an emergency  If you’re married, you and your spouse can each contribute $6,000, for a total of $12,000 (or $11,000 in 2018). Add an additional $1,000 per person to both 2018 and 2019 contributions if either or both of you are age 50 or older. 

Remember the biggest benefit: Money in your Roth grows tax-free until retirement. And when you do retire, you pay no taxes on withdrawals. You also won't be mandated to take required minimum distributions (RMDs) from that account; the money can continue to grow tax free until you need it. (With a traditional IRA, you do pay taxes on withdrawals and taking out a certain amount after age 70½ is required.) 

All this probably sounds way too far in the future to be important. But trust us, it is. See if you qualify and don’t miss out on making this year’s contribution – it’s an opportunity (and future tax break) you’ll never get back.

Here are seven tips for using your Roth IRA as an emergency fund:

The advantage to putting emergency savings into a Roth IRA is that you don't miss the limited opportunity to make that year's retirement contribution. You can only contribute a few thousand dollars to a Roth IRA each year, and once a year passes without a contribution, you lose the opportunity to make it forever.

The more money set aside for retirement and the earlier saving is begun, the better. In reality, most people won't have to go back and withdraw money from their Roth, which means they'll have more saved for retirement. And in a worst-case scenario in which money does have to be withdrawn, it can be done without penalty.

“Roth IRAs remain the most flexible retirement accounts in the country,” says Jeff S. Vollmer, managing director of Hyde Park Wealth Management in Cincinnati.

Accessing these funds, however, should be your last resort.

Matt Becker, a fee-only certified financial planner and author of momanddadmoney.com, points out that you don’t want to be withdrawing Roth IRA contributions for minor emergencies such as car repairs or small medical bills; you should keep enough in savings for these events. Your Roth IRA emergency fund should be for larger emergencies such as unemployment or a serious illness.

Withdrawing Roth contributions is a better option than racking up interest on credit card debt, but it shouldn’t be your sole source of emergency funds. Best is to have a separate emergency fund account as well as the money allocated for emergencies in your Roth.

The key to using a Roth IRA as an emergency fund is to avoid withdrawing investment earnings. While you can withdraw contributions at any time without penalty, withdrawal of earnings before age 59½ means you'll have to pay a 10% penalty on that money. Following this rule is simple: Don’t withdraw more than you’ve put in.

If you do have to withdraw contributions, you can pay yourself back and retain your Roth contribution for that year if you act fast.

“If the emergency turns out to be a short-term cash flow issue that gets resolved quickly, [you] can put the money back into the Roth IRA within 60 days to refund this account,” says certified financial planner Scott W. O'Brien, director of wealth management for WorthPointe Wealth Management in Austin, Texas. Do that and the most you'll lose is a little bit of interest.

"It is critical not to invest the portion of your Roth dedicated to your emergency fund,” says Garrett M. Prom, founder of Prominent Financial Planning in Austin, Texas. “This money is for emergencies, which in most cases is job loss. If that job loss is part of a downturn in the economy, you will have to sell investments, usually at a loss.”

The part of your Roth IRA contribution earmarked as your emergency fund doesn’t belong in stocks, bonds or mutual funds like a typical retirement contribution. It belongs in a liquid account which still earns a bit of interest, but one from which you can withdraw at a moment’s notice without losing principal. Ally Bank, for example, has an IRA savings account that pays 1.85% interest, as of September 2018.

Gains to the Roth account will increase without having to pay taxes on the earnings every year, as would be the case with a regular savings account. You also won’t have to pay tax on these earnings when you withdraw them as qualified distributions once you reach retirement age.

A savings account within a Roth can earn at least as much interest as a regular savings account – if not more, depending on where you bank. If you already have a Roth IRA but your brokerage doesn't have any low-risk places to keep your money while still earning interest, open a second Roth IRA at an institution that does. It’s fine to have multiple Roth IRA accounts, as long as your total contributions to all accounts don’t exceed the annual limit.

Once you have a large enough emergency fund, start moving those contributions into higher-earning investments; you don't want all of your Roth contributions in cash forever. This process might take you a few months or a few years, depending on how quickly you can accumulate additional savings.

If your Roth IRA contains contributions that you converted or rolled over from another retirement account, such as a 401(k) from a former employer, you’ll need to be careful about any withdrawals, because there are special rules about withdrawing rollover contributions. Unless they've been in your Roth for at least five years, you'll incur a 10% penalty if you withdraw them, and each conversion or rollover has a separate five-year waiting period.

Withdrawing rollover contributions penalty-free can be tricky, so it’s a good idea to consult a tax professional if you find yourself in this situation. The good news is that if you have both regular contributions and rollover contributions, the IRS first categorizes your withdrawals as withdrawals of regular contributions before it categorizes them as withdrawals of rollover contributions.

What good is an emergency fund if you can’t access the money when you need it? Funds availability may differ depending on the institution where you keep your Roth and the type of account you place the money in. You don’t want to learn later when you need money urgently, that it will take days to get a check or bank transfer, so find out before making a contribution to your Roth IRA how long it will take to get it back.

Funds can typically be retrieved in less than three business days. If you are taking cash out of a money market or mutual fund and you put in your withdrawal request before 4 p.m. EST, you will have the money by the next business day. If the money is invested in stocks, you will need to wait three business days typically, although if you have a checking account with the same company where you have your Roth IRA, you may be able to get it faster.

A wire transfer can also be a fast way to access funds, though you’ll have to pay a wire transfer fee that’s typically $25 to $30.

“Most brokerage firms can wire funds directly from a Roth IRA to a checking or savings account in one business day, assuming stocks or bonds don't have to be sold to generate cash,” says Accredited Asset Management Specialist Marcus Dickerson of Beaumont, Texas.

These potential delays in Roth IRA fund availability are another reason to keep some emergency cash outside of your Roth IRA, in your checking or savings account, for extremely urgent needs.

Once a particular year's deadline passes for contributing to a Roth IRA, you've lost a chance to contribute for that year forever. Since the Roth has a relatively low annual contribution limit, you don't want to miss out on making the full contribution for any year if you can help it.

The maximum you can contribute for the year, as of tax year 2019, is the lesser of $6,000, or your taxable compensation for the year. If you’re 50 or older, you can contribute the lesser of $7,000 or your taxable compensation for the year. (The figures for 2018 are $5,500 and $6,500, respectively.)

The IRS lowers the Roth IRA contribution limits if your filing status is married filing jointly or qualifying widow(er) and your modified AGI is $193, 000 to $203,000 in 2019 ($189,000 to $199,000 in 2018); if your modified AGI is $203,000 or more ($199,000 or more for 2018), you can’t contribute to a Roth. In 2019 single filers and heads of household hit the reduced contribution threshold at $122,000 and are disqualified once their modified AGI is $137,000 or more (or $120,000 and $135,000, respectively, in 2018).

“Don't forget to fund an account for the low wage or nonworking spouse,” says Amy Rose Herrick, a Chartered Financial Consultant and paid tax preparer in Christiansted, Va. “Too many people assume you have to be earning funds to have your own retirement account. This is not true. You can have what is referred to as a spousal Roth IRA based on the earnings of the working spouse.”

If you do need to withdraw contributions from your Roth IRA to use in an emergency, there’s paperwork involved. Even though you're allowed to withdraw contributions without penalty, you still have to report your withdrawals to the IRS on part III of form 8606.

If you use tax preparation software, it will ask you if you made any withdrawals from a retirement account during the year and guide you through the paperwork. If you use a professional tax preparer, make sure to tell him or her about your withdrawal so he or she can fill out IRS form 8606 for you.

If you only put money in your Roth and don’t take anything out, you have nothing extra to do at tax time. You don’t need to report Roth IRA contributions on your tax return since you’ve already paid tax on that income and contributions don’t reduce your taxable income.

Also, if you make your Roth contribution before the income tax filing deadline for the year and need to withdraw that money before the filing deadline, the IRS treats these contributions as if you had never made them. You won’t need to report them at tax time.

“The Roth IRA is the perfect place to stow those ‘just in case’ funds while also taking advantage of the opportunity for tax-free growth, and tax-free income, in retirement,” Dickerson says.

While the IRS calls the types of withdrawals described in this article “unqualified,” which makes it sound like you’re breaking a rule, it considers them a “return of your regular contributions” and does not tax or penalize them. “Qualified” distributions are simply those that have been in your Roth for at least five years and that you withdraw after age 59½.

You have 15½ months each tax year to accumulate emergency funds to place in a Roth. For tax year 2018, for example, you can make contributions through April 15, 2019. For tax year 2019, you can make contributions from Jan. 1, 2019 through April 15, 2020.