The Roth Emergency Fund

by Joe on July 19, 2012

In financial matters there are the rules of thumb such as “save 10-15% of your income” or “have 6 months living expenses as an emergency account.” Good thoughts in general. There’s also the warning that tapping one’s retirement savings for emergencies should be avoided at all cost.

When we dig deeper, personal finance is, well, personal. A reader wrote to me:

“I am mid-20’s, saving 10% in my 401(k), 8% is matched. My budget isn’t too tight, but after moving into the new house (3.75% 30 year loan!), I’d like to work on building our emergency account. We are under the income cutoff for Roth IRAs, what do think of us putting this money into the Roth, in case no emergency comes up?” thanks, Louis

Excellent idea, Louis, and one of the best kept secrets of the Roth IRA. As you know, but maybe not all my readers do, Roth deposits may be withdrawn any time without penalty. For most people, the “don’t tap your retirement savings for emergencies” is great advice, but this really isn’t your situation. You’re savings total 18% of your income, tough to argue with that. As I see it, you’re really looking for a safe place to build an emergency fund, and you happen to have no need for the Roth for retirement, not yet, anyway.

If we look at the big picture, there are two possibilities – say Louis has to withdraw the money at some point. The entire amount deposited is available with no tax or penalty due. In today’s interest rate environment, the bulk of the account will be his deposits (and his wife’s, they can each start a Roth). If no such need arises, and the Roth grows beyond the size to help with normal emergencies, they can begin to shift to long term investments within the Roth. Another thought, is they can shift how they view these accounts from ’emergency’ to ‘college’ savings. When the time comes to applying for tuition aid, retirement savings are not counted as highly as non-retirement assets.

The Roth IRA has some hidden potential, more than just a retirement account if you know the rules.

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