How good are Roth IRA’s for emergency funds?

Roth IRA’s are interesting vehicles because, among other things, contributions can be withdrawn at any time penalty-free. Since contributions are capped annually but can be withdrawn at any time penalty-free, this leads to the following logic: make your maximum contribution each year whether or not you intend to invest it. After all, if you need the money later you can always withdraw the contribution penalty-free, but if you don’t need the money you haven’t forfeited that year’s contribution eligibility.

I think this is good and true, as far as it goes, but if you plan on doing it there are some things you need to take into account.

An advantage of tax-advantaged accounts is tax-free compounding

Depending on which marginal income tax bracket you fall into, long term capital gains and dividends paid on taxable accounts are subject to a marginal income tax rate between 0% and 23.8%. Capital gains and dividends realized within a tax-advantaged account like a Roth IRA aren’t taxed when they accrue, and if withdrawn during retirement or for other qualified distributions are never taxed at all (in a traditional IRA they’re taxed at your marginal income tax rates in retirement). Hence the “advantage” in “tax-advantaged account.”

The problem with using a tax-advantaged account — even one without penalties for the early withdrawal of contributions — is that in order to preserve your capital you have to invest in risk-free or low-risk assets, which won’t produce the dividends and capital gains tax-advantaged accounts are designed to shield from taxation!

To use a Roth IRA as an emergency fund, pair in-account and out-of-account transactions

The solution to this riddle isn’t very complicated, but you need to be aware of it if you’re going to implement it properly. To explain, I’ll give a stylized example.

Say your desired emergency fund is $11,000, whether that’s 3 months, 6 months, or 2 years of emergency expenses — I don’t have a preferred theory for how many months’ expenses you need in your emergency fund. You have room in your budget to save $105 per week — $5,500 per year, the current annual IRA contribution limit.

In order to keep from losing your current-year IRA contribution limit, you contribute $105 per week to a Roth IRA, and leave it invested in cash, a money market account, or very short term bonds. Should you need the money for emergency expenses, it’ll be there waiting for you (assuming you can communicate with your custodian to request the withdrawal!).

At the end of the second year, you’ll have $11,000 in your Roth IRA, and your emergency fund will be “full.” God willing, you won’t have faced an emergency, and so can start directing your weekly contributions to actual investments with an appropriate risk profile and time horizon.

What happens if you find over the course of time that you’re able to save more than $105 per week? Each dollar you save outside your Roth IRA can be paired with a dollar moved from your Roth IRA “emergency fund” to actual investments. This pairing of in-account and out-of-account transactions mean that your investments most likely to increase in value (creating capital gains) and pay dividends or coupons are inside the advantaged account, while your safest, least likely to appreciate assets are held outside the advantaged account (I like Consumers Credit Union’s Free Rewards Checking).

I don’t think much of Roth IRA’s as emergency funds, but they’re great for investments on different time horizons

The objection I have to using Roth IRA’s as emergency funds is that an emergency fund, by definition, has a time horizon of zero, and on a zero time horizon you’re forfeiting a key advantage of a tax-advantaged account.

On the other hand, using Roth IRA’s for tax-free compounding of assets on time horizons other than retirement is a great idea! That’s because in addition to contributions, earnings on Roth IRA’s can be withdrawn penalty-free under a variety of circumstances, including most importantly the purchase of a first home (up to $10,000 in earnings) and paying for qualified education expenses (unlimited earnings).

I don’t know if a perfect solution exists for doing this, but it would be easy to come up with a simple kludge. For example, if you plan to buy a house in 5 years, and pay for higher education in 25 years, you could split your contributions between appropriately-dated target retirement date funds:

• In the event of a bull market the higher education fund would rise faster than the housing fund (being more heavily allocated to equities), and when you achieved $10,000 in earnings you could move your total contributions to date, plus $10,000, to cash in preparation for your withdrawal and house purchase;
• In the event of a bear market, the housing target date fund would decline less than the higher education fund (being allocated more heavily to bonds), preserving your housing purchasing power.

Conclusion

The high degree of flexibility in Roth IRA withdrawals makes them so useful that it leads some people to become a little too enthusiastic about the accounts. They are flexible, and they are useful, but they’re most useful when they’re used for the goals they’re best designed for.