Roth IRA: an alternative emergency fund vehicle

By John Weber

When most people think of a Roth IRA, they think of retirement — and rightly so. The Roth IRA is one of the best vehicles available for investors to save for retirement. There is also an advantage of the Roth IRA that few other types of retirement accounts have, and that is to withdraw contributions without tax or penalty at any time. In this article, I’ll go over who is eligible to contribute to a Roth IRA and consider how the account could serve as an emergency fund.

What is a Roth IRA?

Contributions to a Roth IRA are after-tax, meaning an individual can contribute funds that they have already paid taxes on and therefore do not receive any type of deduction for their contributions. For 2022, the IRS has set a contribution limit of $6,000 per year for people under 50 and an additional $1,000 per year ($7,000 total) for people over 50 at catch-up title. Once an individual’s Roth IRA has been open for at least five years and they have reached age 59.5, they can withdraw income tax and without penalty. Best of all, Roth IRAs aren’t subject to required minimum distributions (RMDs) after age 72, meaning an investor could use their Roth as an inherited or inherited vehicle. So why isn’t everyone contributing to a Roth given these benefits? The IRS has set income limits for people who contribute to a Roth IRA. For 2022, here are the income phase-out ranges according to the IRS website:

Roth IRA Contribution Phase-Out Ranges

  • Only: $129,000 – $144,000
  • Married filing jointly: $204,000 – $214,000
  • Groom filing separately: $0 – $10,000

Even with these phase-outs, high earners still have a way to contribute to a Roth IRA, often referred to as the “Backdoor Roth.” High-income earners can “convert” traditional IRA funds by paying taxes on the distribution and then contributing that amount to their Roth IRA. Roth Backdoors are considered a “loophole” in tax law and are available to any investor, regardless of income level.

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Roth IRA as an emergency fund

Most people use a regular savings account (or maybe a high yield savings account) for their emergency fund. The “rule of thumb” in personal finance is to set aside 3-6 months of living expenses for emergencies. In principle, this is an excellent safety net should someone lose their job or should a major unforeseen event or expense arise. Something not many people consider is that in the event that someone loses their job, they could implement many other financially sound practices during this time, such as: reducing discretionary spending and/or quitting spending. save until he gets back on his feet. In this case, they may actually be spending less than they normally would and need a smaller emergency fund balance as a result.

As with everything else, there is an opportunity cost to having so much money in the bank. Most high-yield savings accounts earn about 0.50%, much better than the average savings account, but significantly less than an investor might be able to earn in their Roth IRA. One of the nice things about the Roth IRA is the ability to take contributions at any time, without tax or penalty, no matter how long the account has been open. This provides another way to access cash in an emergency. If an investor is considering this strategy, it may reduce the need to keep their entire emergency fund in a savings account. If they need to access the money, it’s a transfer, but if they don’t, then the money stays in the Roth IRA and enjoys higher growth than in an account. ET savings contribute to the investor’s retirement goals (assuming it is invested more aggressively than cash).

An important note to consider is the financial effect of withdrawing contributions from a Roth IRA. if a person needed the funds for an emergency. Withdrawing from a Roth IRA would reduce retirement assets and could impact retirement goals. For investors with a smaller Roth IRA, it may not be the best idea to treat the contributions in their Roth IRA as disposable cash, as they would like those assets to benefit from compound interest instead for as long as as possible. If a person has been contributing for several years and therefore has a larger Roth IRA account balance, this strategy may be useful.

Using Roth IRA contributions as part of your emergency fund isn’t for everyone, and it’s important to understand how it might affect you. For specific investment and savings expertise, I would consult with an advisor to determine if this strategy is right for you.

About the Author: John Weber

John Weber is a financial planning partner at Omega Wealth Management, a financial life planning firm based in Arlington, Virginia. Omega Wealth Management‘s goal is to get to know clients on a personal level, integrating their values, vision and wealth to provide holistic and comprehensive financial planning. John can be reached at [email protected]

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