Roth IRA as an emergency fund

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As described in Roth IRA as an emergency fund, in certain appropriate cases, a Roth IRA can serve as a temporary emergency fund. The case study below outlines with specific details how this can be accomplished. Please see the linked page for more information on suitability of this tactic, including linked forum threads with additional details and other considerations.

Overview

In this case study, we start with a working person's portfolio who has a $13,000 emergency fund in a taxable account, and who is contributing to her 401(k) but not enough to maximize her contributions to $17,500 (which is the limit in 2014 for people under 50 years old) or to contribute to her Roth IRA.

In her situation, since she is not maximizing her tax-advantaged savings, she could shift up to $5,500 (which is the limit for Roth IRA contributions in 2014 for people under 50, assuming she is eligible) from her emergency fund in her taxable account, into her Roth IRA.

If she is maximizing her tax-advantaged savings, then this case study is not applicable. In that case, emergency funds should be held in a taxable account.

The reason for doing this is that at some point in the future, she might be able to maximize her tax-advantaged savings and still have enough left over to replenish her emergency fund in her taxable account. For each dollar she can replenish her emergency fund in the taxable account, she can "transfer" a dollar within her IRA account from being set aside for emergencies, to being set aside for retirement. Eventually, she can fully replenish her emergency fund in a taxable account and then "transfer" all the Roth IRA assets that had previously been set aside for emergency fund purposes into assets allocated for retirement. This essentially allows a person to make more contributions to tax-advantaged accounts than you ordinarily could in a given tax year.

If, before that milestone can happen, an emergency occurs and those funds are needed, she can withdraw them from her Roth IRA account and pay for the emergency. In this case, she has lost nothing because that money would have been in a taxable account anyway.

But if no emergency occurs, or if the emergencies are less than the amount that was transferred into the Roth IRA, then after replenishing the emergency fund in a taxable account, the portfolio can have a boost in retirement assets in the Roth IRA that otherwise would have had to be invested in a taxable account.

Note that throughout the entire case study, she always has $13,000 in her emergency fund -- that never changes. What does change is that the location of those funds moves from the taxable account, to the Roth IRA (except for $2,000), and then back to the taxable account.

Considerations

Before undertaking this tactic, be aware of the following:

  • Since emergency funds should be stable and not volatile, you should put your emergency fund in a Roth IRA in a fund that will hold its value reliably.
  • Roth IRA rules allow withdrawals on contributions but there can be penalties on withdrawing earnings.[footnotes 1] This is one disadvantage of this tactic, because if the emergency funds were in a taxable account, then you could count on your emergency fund to grow slightly from earnings. With all or part of your emergency fund in a Roth IRA, however, you won't be able to access those gains without paying a penalty.
  • In developing a retirement portfolio's overall Asset allocation, having all or part of a Roth IRA allocated toward an emergency fund can complicate the math. You should make sure to exclude the emergency fund portion in a Roth IRA from your overall asset allocation as it pertains to your retirement assets.
  • For behavioral and psychological reasons, investors are advised to avoid "raiding" retirement accounts which is why an emergency fund is typically held in a taxable account and not in tax-advantaged accounts intended for retirement savings. Therefore, an investor undertaking this tactic must have the discipline and account management skills to keep the emergency fund portion of her Roth IRA separate from the retirement portion. This principle can be made easier to follow by putting these amounts in different mutual funds.

Case study

The following shows a detailed illustration over a 5-year period. After Year 5, a summary is shown of the potential benefits of undertaking this tactic of using one's Roth IRA to hold emergency funds, versus leaving the emergency fund in the taxable account.

Assumptions

  • For simplicity, this case study does not consider inflation or investment returns or taxes from one year to the next.
  • For simplicity, it is assumed that the $13,000 that is deemed necessary for an emergency fund remains constant over the course of this case study, even though in real life that amount might need to rise over the years.
  • For simplicity, only two mutual funds are considered: money market for emergency fund, and stocks for retirement.
  • The investor is an employed person under the age of 50 years old.
  • The maximum amount the person may contribute is $17,500 to a 401(k) and $5,500 to a Roth IRA (as this was updated in 2014 when those were the limits).
  • The person is eligible to contribute $5,500 to a Roth IRA.

Year 0

Starting out you have the following:

Taxable Account

Fund Balance Allocated Toward
Money Market $13,000 Emergency Fund

Roth IRA

Fund Balance Allocated Toward
Stocks $3,000 Retirement

401(k)

Fund Balance Allocated Toward
Stocks $12,000 Retirement

Overall

Category Balance
Retirement $15,000
Emergency Fund $13,000
TOTAL $28,000

Year 1

At the end of Year 1, you can contribute $15,000 to the 401(k).

Since you have not exhausted all your tax-advantaged space, you can move part of your emergency fund in the taxable account to the Roth IRA by making a $5,500 deposit into it, leaving behind $7,500 in the taxable account. You still have $13,000 in your emergency fund, only now it's split between two different accounts.

This leaves you with:

Taxable Account

Fund Balance Allocated Toward Note
Money Market $13,000 Emergency Fund Beginning balance
Money Market - $5,500 Emergency Fund Withdrawal for IRA contrib
Money Market TOTAL $7,500 Emergency Fund  
 
ACCOUNT TOTAL $7,500  

Roth IRA

Fund Balance Allocated Toward Note
Stocks $3,000 Retirement Beginning balance
Stocks TOTAL $3,000 Retirement
 
Money Market   $0.00 Emergency Fund Beginning balance
Money Market + $5,500 Emergency Fund Transfer from taxable emergency fund
Money Market TOTAL $5,500 Emergency Fund  
 
ACCOUNT TOTAL $8,500  

401(k)

Fund Balance Allocated Toward Note
Stocks $12,000 Retirement Starting balance
Stocks + $15,000 Retirement Contribution
Stocks TOTAL $27,000 Retirement
 
ACCOUNT TOTAL $27,000  

Overall

Category Balance
Retirement $30,000
Emergency Fund $13,000
TOTAL $43,000

Year 2

For Year 2, now you can contribute $17,500 to the 401(k) but that is the most you can do. You can shift another $5,500 from your taxable account into the Roth IRA, allocated toward the emergency fund. You still have $2,000 left over in the taxable account. Your overall emergency fund is still at $13,000, only you have $2,000 in taxable and $11,000 in the Roth IRA.

Taxable Account

Fund Balance Allocated Toward Notes
Money Market $7,500 Emergency Fund Beginning Balance
Money Market - $5,500 Emergency Fund Withdrawal for IRA contrib
Money Market TOTAL $2,000 Emergency Fund  
 
ACCOUNT TOTAL $2,000  

Roth IRA

Fund Balance Allocated Toward Notes
Stocks $3,000 Retirement Starting balance
Stocks TOTAL $3,000 Retirement
 
Money Market $5,500 Emergency Fund Beginning balance
Money Market + $5,500 Emergency Fund Transfer from taxable emergency fund
Money Market TOTAL $11,000 Emergency Fund  
 
ACCOUNT TOTAL $14,000  

401(k)

Fund Balance Allocated Toward Notes
Stocks $27,000 Retirement Beginning balance
Stocks + $17,500 Retirement Contributions
Stocks TOTAL $44,500 Retirement
 
ACCOUNT TOTAL $44,500  

Overall

Category Balance
Retirement $47,500
Emergency Fund $13,000
TOTAL $60,500

Year 3

In Year 3, you now can contribute a total of $23,000 to max out your tax-advantaged space, with $17,500 to 401k and $5,500 to Roth IRA. There is no longer any more room in the Roth IRA to shift emergency fund money.

At the end of the year, the accounts look like this:

Taxable Account

Fund Balance Allocated Toward Notes
Money Market $2,000 Emergency Fund Beginning Balance
Money Market TOTAL $2,000 Emergency Fund  
 
ACCOUNT TOTAL $2,000  

Roth IRA

Fund Balance Allocated Toward Notes
Stocks $3,000 Retirement Starting balance
Stocks + $5,500 Retirement Annual IRA Contribution
Stocks TOTAL $8,500 Retirement
 
Money Market $11,000 Emergency Fund Beginning balance
Money Market TOTAL $11,000 Emergency Fund  
 
ACCOUNT TOTAL $19,500  

401(k)

Fund Balance Allocated Toward Notes
Stocks $44,500 Retirement Beginning balance
Stocks + $17,500 Retirement Contributions
Stocks TOTAL $62,000 Retirement
 
ACCOUNT TOTAL $62,000  

Overall

Category Balance
Retirement $70,500
Emergency Fund $13,000
TOTAL $83,500

Year 4

In Year 4, you now can contribute a total of $23,000 to max out your tax-advantaged space, and you still have another $4,000 to save. With that additional $4,000, you can start to rebuild your emergency fund in the taxable account. So, add $4,000 to your taxable account and allocate it toward the emergency fund. At the same time, you can re-allocate an equal portion in your Roth IRA ($4,000) from being allocated to emergency fund to being allocated to retirement by transferring $4,000 from the money market fund to the stock fund that is allocated for retirement.

At the end of the year, the accounts look like this:

Taxable Account

Fund Balance Allocated Toward Note
Money Market $2,000 Emergency Fund Beginning Balance
Money Market + $4,000 Emergency Fund Contribution
Money Market TOTAL $6,000 Emergency Fund  
 
ACCOUNT TOTAL $6,000 Emergency Fund  

Roth IRA

Note that the exchange from the Money Market fund to the Stock fund all happens within the same Roth IRA account.

Fund Balance Allocated Toward Note
Stocks $8,500 Retirement Starting balance
Stocks + $5,500 Retirement New Annual Contribution
Stocks + $4,000 Retirement Exch from Money Market
Stocks Total $18,000 Retirement  
 
Money Market $11,000 Emergency Fund Starting balance
Money Market - $4,000 Emergency Fund Exch to Stocks/Retirement
Money Market Total $7,000 Emergency Fund  
 
ACCOUNT TOTAL $25,000    

401(k)

Fund Balance Allocated Toward Note
Stocks $62,000 Retirement Beginning Balance
Stocks + $17,500 Retirement Contribution
Stocks TOTAL $79,500 Retirement
 
TOTAL $79,500 Retirement  

Overall

Category Balance
Retirement $97,500
Emergency Fund $13,000
TOTAL $110,500

Year 5

In Year 5, you can contribute a total of $23,000 to max out your tax-advantaged space, and you have an additional $7,000 to save. Similar to what you did in Year 4, add the $7,000 to your taxable account and allocate it toward your emergency fund. With the addition of $7,000 to your emergency fund in the taxable account, you can exchange the $7,000 in the Roth IRA account that is allocated to the emergency fund, to retirement. You've now built your emergency fund back up in the taxable account.

At the end of this year, your Roth IRA is now allocated 100% to your retirement allocation, and 100% of your emergency fund is back in the taxable account.

At the end of the year, the accounts look like this:

Taxable Account

Fund Balance Allocated Toward Note
Money Market $6,000 Emergency Fund Beginning Balance
Money Market + $7,000 Emergency Fund Contribution
Money Market TOTAL $13,000 Emergency Fund  
 
ACCOUNT TOTAL $13,000 Emergency Fund  

Roth IRA

Note that the exchange from the Money Market fund to the Stock fund all happens within the same Roth IRA account.

Fund Balance Allocated Toward Note
Stocks $18,000 Retirement Starting balance
Stocks + $5,500 Retirement New Annual Contribution
Stocks + $7,000 Retirement Exch from Money Market
Stocks Total $30,500 Retirement  
 
Money Market $7,000 Emergency fund Starting balance
Money Market - $7,000 Emergency fund Exch to Stocks/Retirement
Money Market Total $0.00 Emergency fund  
 
ACCOUNT TOTAL $30,500    

401(k)

Fund Balance Allocated Toward Note
Stocks $79,500 Retirement Beginning Balance
Stocks + $17,500 Retirement Contribution
Stocks TOTAL $97,000 Retirement
 
TOTAL $97,000 Retirement  

Overall

Category Balance
Retirement $127,500
Emergency Fund $13,000
TOTAL $140,500

Summary of Case Study

If you had left your emergency fund in the taxable account all along, then you wouldn't have been able to get the extra $11,000 of savings in Year 4 and Year 5 into the Roth IRA. Instead, in Year 4 when you have an additional $4,000 to invest, you would only be able to add it to a stock/retirement fund in taxable account, and in Year 5, when you have an additional $7,000 to invest, you would only be able to invest it into the same taxable account.

What both scenarios have in common is that at the end of Year 5, you have $13,000 in the emergency fund in the taxable account, and both scenarios have an identical amount in the 401(k).

But in the Roth as Emergency Fund scenario you have $11,000 more in the Roth IRA. Here is a summary of all retirement assets in the taxable account and the Roth IRA account at the end of Year 5 when you use the Roth IRA as an emergency fund:

Account Balance
Taxable $0.00
Roth IRA $30,500
TOTAL $30,500

By contrast, here is what your accounts look like if you never availed yourself of the Roth IRA as an emergency fund:

Account Balance
Taxable $11,000
Roth IRA $19,500
TOTAL $30,500

Clearly, the first option is superior because you have all $30,500 in the Roth IRA.

Variations

Variations with this case study:

  • If the person had to make a withdrawal from the Roth IRA for an emergency, then that would simply deduct that portion from the Roth IRA. Withdrawals for emergencies should start in the taxable account (if there are any emergency funds in the taxable account) first and then move to the Roth IRA. That would, consequently, leave less money to "transfer" from emergency fund to retirement if/when the investor can replenish her emergency fund in a taxable account.
  • If this person's income and ability to save had not risen as fast, then the remaining $2,000 in the taxable account could have been transferred in Year 4 into the Roth IRA.
  • This case study began with someone who already has an emergency fund. This case study could also be adapted for someone who is just building an emergency fund. In that case, contributions to the emergency fund could go into the Roth (up to the maximum amount allowed per year).

Notes

  1. Earnings of contributions withdrawn before the due date of that year will be taxed. See IRS Publication 590: Are Distributions Taxable?

See also