Using a Roth IRA for investing an emergency fund

El Ingeniero

Level 2 Member
It's my understanding that Roth contributions can be withdrawn tax and penalty free. I did not know this until yesterday, and I consider it a bit of a game changer.

Since I presently have a sizable emergency fund, I would be able to make a maximum Roth contribution for most of the next decade, as long as my income doesn't bump up against IRS limits.

Goes without saying that I'd be putting no more than 33% of that into equities and the rest into intermediate term bonds.

For the bond allocation, BIV. There is also IEF, but that has a much higher (3X) expense ratio, and is more interest rate sensitive because of its longer average duration.

For the equity allocation, I was thinking PUTW. It puts its funds into short term bonds, and sells at-the-money puts on SPY. Returns are not as nice as SPX or IVV, but it's way less volatile (though I realize it would probably drop just almost as much as SPY).

Am I missing something here?
 

volker

Level 2 Member
It's correct that you can withdraw the paid in money of Roth IRA's penalty free. But this only works after 5yrs. So if you pay in now 5k per year for the next 5 years you can't withdraw the full 25k in 5yrs but only 5k.

There are other exceptions where you can withdraw penalty free like for a mortgage (capped) or education. But I would think 10x about it before I would do that.

Withdrawing from a Roth comes also with a risk. I don't recall ever seeing an Roth IRA investment option that paid you reliable 1%/yr in interest and even bond prices fluctuate. If the market crashes you likely have a dip in your emergency fund -- and bonds can also go significantly down.


You could also take a look into i-Bonds. I like them for emergency fund diversification. Sometimes you win (high inflation), sometimes you loose (negative inflation) compared to a 1% savings account, but at least your money doesn't loose value due of inflation. And if you invest during a high yield period (whenever this will happen again...) you might be well off. You can withdraw i-Bonds after 11months.
There is an annual contribution limit for iBonds, I think its 10k/yr/person, but there is a workaround through tax refunds.

I myself have some cash in a 1% saving account (yes, I should move them to some 5% accounts that come with a 5k or similar cap), i-Bonds for 2nd level and I only consider my Roth for when everything will be 10x as bad as in my worst-worst-worst case scenario. That means my Roth is for retirement and not really for emergency savings. But its good to know that its there if everything goes wrong.
 

El Ingeniero

Level 2 Member
I just read this article that came up on DoC. It's also an interesting approach: http://moneymetagame.com/fi/how-to-use-your-mortgage-as-a-high-interest-savings-account/
That's OK, but it has diminishing returns: For my mortgage, a $10K payment toward principal next month, would result in $13,422 of interest savings, but a $30K payment would only net $33,738 in interest savings.

And there is the additional risk that you need to draw down on the HELOC for an extended period without a source of income.
 

Matt

Administrator
Staff member
Roth withdrawals are a little confusing because of overlapping rules. In short:
  1. Roth contributions (not earnings) can be withdrawn at any time without penalty.
  2. Roth conversions (from Trad or 401(k)) have a 5 year waiting period.
  3. Roths in retirement need to exist for 5 years before you can make qualified withdrawals
So if you open up a Roth today, fund it with the $5500, it grows to $6500 overnight, you could pull out $5500 tomorrow.

In terms of using one as an EF. Not a bad idea if you are sophisticated enough to manage it. Certainly is more convoluted to access the cash in the event of a real emergency. If you have the knowledge and ability to create liquid cash via a MS technique, that can help too, but everything you're doing here is more risky than being boring with your cash. You might consider if the risk is worth it.

EG what is $20K of Emergency Fund at 1% vs 4% worth annually after tax, and is that alpha worth the hassle? Also, if you have a plan that involves buying GCs until you've processed the Roth paperwork, does your Spouse know how that works if the emergency is you being kidnapped while trekking in the Amazon rainforest?

Remember, some emergencies can be foreseen more than others. If your roof is 16yrs old and you have no warranty, there's more chance of an emergency than a 1yr old roof that is under warranty for the next 5yrs.


@El Ingeniero not specific advice here, but generally my thinking:

I'm conservative by nature, and based on current market conditions I certainly put in less to equities than is the 'norm'. However, 33% equities is very conservative. I tend to find most people ranging from 50%-70% after I've worked on things with them. Obviously this is very generic, and for illustration.

I do not have, nor generally recommend having, a mortgage in for most cases. I personally think they are useful to help you gain access to a property beyond your immediate ability at closing, but after that, I like to pay them off quickly.

Simple logic here is that mortgages offer a guaranteed rate of return which exceeds anything that is available at the moment, so I take advantage of that.

I don't mess around with things like PUTW.
 

Differentplanet

Level 2 Member
I do not have, nor generally recommend having, a mortgage in for most cases. I personally think they are useful to help you gain access to a property beyond your immediate ability at closing, but after that, I like to pay them off quickly.
Assuming a 15 year fixed mortgage of ~3.5%, why would you accelerate the payments?
Money has never been this cheap before.
 

Matt

Administrator
Staff member
Assuming a 15 year fixed mortgage of ~3.5%, why would you accelerate the payments?
Money has never been this cheap before.
Simple logic here is that mortgages offer a guaranteed rate of return which exceeds anything that is available at the moment, so I take advantage of that.
I hear the 'money is cheap' line. But let me ask you, do you think that mortgage companies make a profit or not?

Let's assume that mortgages make profit from lending money at 3.5%, and are happy to do so, how are you able to 'profit' on top of that?

It all comes down to the risk free rate of return. They lend to you, you hope to make a gain on the spread, but you are taking on risk that they are not, because if you mess up, they lien your house. Then you find yourself somewhere on this spectrum:

  1. You borrow at 3.5% and make a gain from the market (this is like investing on margin, speculating)
  2. You borrow at 3.5% and lose enough that you can survive, but have to save more, or delay retirement to keep afloat.
  3. You borrow at 3.5% and lose so much that you cannot survive, and lose your downpayment and equity.
Plus, the big thing that everyone forgets is that the 3.5% is constant (guaranteed, risk free rate of return) whereas your speculation money isn't. Sometimes you leave $10K too much in checking, making 0.015% APR. Sometimes, your investments decline.

The only real mortgage bet that I see is that you can hold onto that line of credit until the risk free investment rate exceeds the current mortgage rate. You could argue for a 30 year bond arbitrage, but who wants to hold those in a raising rate environment? I can't see liquid investments (like a bank account) exceeding 3.5% anytime soon, so I say take the easy money.
 

El Ingeniero

Level 2 Member
The point of having an emergency fund in my case is to deal with loss of employment income in the short to medium term.

Moving cash from the emergency fund to mortgage principal requires an quick home sale or secondary mortgage for short-term liquidity. A quick home sale might mean selling for under market value. A secondary mortgage (HELOC) has an interest rate, and you could borrow so much that I lose everything or spend a long time digging myself out. The net effect is that I do better if things go well, and worse if things go badly. The worse if things go badly part is what has me worries.
 
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