Using Backdoor Roths for Emergency Fund

[erebusxc47]

Are they any pitfalls into putting a substantial amount of your emergency fund into a roth [would have to backdoor for wife and me]? Would like to fund 2020 roths before April 2021 tax date at $6k/each - but that would leave maybe only a month of cash on hand in my regular HYSA. The roths would be invested in something very low risk [money market fund perhaps] until I could build 3 - 6 months cash in the HYSA, at which point, I would re-allocate the roths to something more in line with my target 70% stock/30% bond portfolio.

If something happened and we had to tap into the Roth contributions [would avoid taking out any investment gains if possible], then I *think* the worst thing that would happen would be that we basically lose the 2020 roth contributions; which isn't any different from just having it sit in my HYSA the entire time. Alternatively, if things remain peachy, I am able to take advantage of the 2020 roth contribution. Seems like very little downside risk and a decent amount of upside potential. Am I missing something?

[mhalley]

You are missing that if you take out money from the roth, you are not just taking out that money, you are taking out 30-40 years of compounding. So while you think you took out $10k to pay for the roof, you actually took out $57,432 - $102,857 if you think the market will do 6%.

[tashnewbie]

OP: I agree that it'd be preferable to put this money in a Roth IRA versus leaving it in HYSA, if you can't do both. If you can fund the Roth IRAs and maintain your desired emergency fund/cash reserves in HYSA, then obviously that's the best option.

Yeah, if you have a true emergency and need the Roth IRA contributions, then they're available to use, but you would lose out on years of compounding by taking the money out. But I don't think you're in any worse position than you would've been in had you not funded the Roth IRA and left the money in HYSA.

Be aware of the 5-year rule and ordering rules for Roth conversions. If you're doing a regular backdoor contribution and converting the TIRA amount shortly after funding the TIRA, then you shouldn't have to worry about paying an early withdrawal penalty on taxable converted amounts (because there wouldn't be any taxable earnings associated with the converted principal or they'd be relatively low).

[willthrill81]

You are missing that if you take out money from the roth, you are not just taking out that money, you are taking out 30-40 years of compounding.

That's true, but since the OP isn't already maxing out a backdoor Roth, then s/he is already missing out on that compounding.

Based on my observations of the experiences of those here, emergency funds are seldom raided in their entirety. The OP is very likely to benefit from the proposed strategy.

[erebusxc47]

OP: I agree that it'd be preferable to put this money in a Roth IRA versus leaving it in HYSA, if you can't do both. If you can fund the Roth IRAs and maintain your desired emergency fund/cash reserves in HYSA, then obviously that's the best option.

Yeah, if you have a true emergency and need the Roth IRA contributions, then they're available to use, but you would lose out on years of compounding by taking the money out. But I don't think you're in any worse position than you would've been in had you not funded the Roth IRA and left the money in HYSA.

Be aware of the 5-year rule and ordering rules for Roth conversions. If you're doing a regular backdoor contribution and converting the TIRA amount shortly after funding the TIRA, then you shouldn't have to worry about paying an early withdrawal penalty on taxable converted amounts (because there wouldn't be any taxable earnings associated with the converted principal or they'd be relatively low).

Can you elaborate on the 5-year rule and ordering rules? We are ages 30 and 29 currently if that means anything.

[willthrill81]

OP: I agree that it'd be preferable to put this money in a Roth IRA versus leaving it in HYSA, if you can't do both. If you can fund the Roth IRAs and maintain your desired emergency fund/cash reserves in HYSA, then obviously that's the best option.

Yeah, if you have a true emergency and need the Roth IRA contributions, then they're available to use, but you would lose out on years of compounding by taking the money out. But I don't think you're in any worse position than you would've been in had you not funded the Roth IRA and left the money in HYSA.

Be aware of the 5-year rule and ordering rules for Roth conversions. If you're doing a regular backdoor contribution and converting the TIRA amount shortly after funding the TIRA, then you shouldn't have to worry about paying an early withdrawal penalty on taxable converted amounts (because there wouldn't be any taxable earnings associated with the converted principal or they'd be relatively low).

Can you elaborate on the 5-year rule and ordering rules? We are ages 30 and 29 currently if that means anything.

That does not apply to your own contributions, as discussed here. Contributions to Roth IRAs can be withdrawn at any time with no penalty.

[nolesrule]

There may be other issues that need to be addressed if at the income level required for a married couple to need to do a backdoor Roth they cannot also adequately save cash for an emergency fund.

[tashnewbie]

Can you elaborate on the 5-year rule and ordering rules? We are ages 30 and 29 currently if that means anything.

See the Kitces article linked below for information about the 2 five-year rules. One relates to the ability to withdraw Roth IRA earnings tax-free and the other relates to penalty-free withdrawals of converted amounts. The latter is what I was referencing.

https://www.kitces.com/blog/understandi ... nversions/

I agree with another poster...you should examine your spending. If you're MFJ (or single) and need to utilize the backdoor Roth IRA, you should easily be able to maintain desired cash reserves and contribute to Roth IRAs. Maybe you have a lot of debt you're servicing?

[willthrill81]

Can you elaborate on the 5-year rule and ordering rules? We are ages 30 and 29 currently if that means anything.

See the Kitces article linked below for information about the 2 five-year rules. One relates to the ability to withdraw Roth IRA earnings tax-free and the other relates to penalty-free withdrawals of converted amounts. The latter is what I was referencing.

https://www.kitces.com/blog/understandi ... nversions/

I agree with another poster...you should examine your spending. If you're MFJ (or single) and need to utilize the backdoor Roth IRA, you should easily be able to maintain desired cash reserves and contribute to Roth IRAs. Maybe you have a lot of debt you're servicing?

The 5 year rule is not applicable to direct Roth IRA contributions, which is what the OP is doing. I don't see the need for bringing up the 5 year rule and potentially confusing the OP.

[tashnewbie]

The 5 year rule is not applicable to direct Roth IRA contributions, which is what the OP is doing. I don't see the need for bringing up the 5 year rule and potentially confusing the OP.

In OP's original post, they say they will have to use the backdoor. Therefore, the other 5-year rule will be applicable. Maybe OP doesn't need to use the backdoor. If he doesn't and will only make direct contributions, then yeah, don't worry about the 5-year rules.

[willthrill81]

The 5 year rule is not applicable to direct Roth IRA contributions, which is what the OP is doing. I don't see the need for bringing up the 5 year rule and potentially confusing the OP.

In OP's original post, they say they will have to use the backdoor. Therefore, the other 5-year rule will be applicable. Maybe OP doesn't need to use the backdoor. If he doesn't and will only make direct contributions, then yeah, don't worry about the 5-year rules.

From the OP:

If something happened and we had to tap into the Roth contributions [would avoid taking out any investment gains if possible], then I *think* the worst thing that would happen would be that we basically lose the 2020 roth contributions; which isn't any different from just having it sit in my HYSA the entire time.

emphasis added

[tashnewbie]

From the OP:

If something happened and we had to tap into the Roth contributions [would avoid taking out any investment gains if possible], then I *think* the worst thing that would happen would be that we basically lose the 2020 roth contributions; which isn't any different from just having it sit in my HYSA the entire time.

emphasis added

From the OP (emphasis added):

Are they any pitfalls into putting a substantial amount of your emergency fund into a roth [would have to backdoor for wife and me]?

OP needs to figure out what he's doing. If he is indeed doing "normal" backdoor conversions, converting shortly after the TIRA contribution, then even the second 5-year rule is basically a non-issue, because the taxable portion of the converted amounts will be relatively small or non-existent. I mentioned the 5-year rule related to conversions to warn the OP that he should convert the TIRA contributions soon after making them, so that withdrawals are less complicated.

If he's making only direct contributions to Roth IRA, then he doesn't need to worry about the 5-year rules, and can remove the contributions at any time, tax- and penalty-free.

[erebusxc47]

From the OP:

If something happened and we had to tap into the Roth contributions [would avoid taking out any investment gains if possible], then I *think* the worst thing that would happen would be that we basically lose the 2020 roth contributions; which isn't any different from just having it sit in my HYSA the entire time.

emphasis added

From the OP (emphasis added):

Are they any pitfalls into putting a substantial amount of your emergency fund into a roth [would have to backdoor for wife and me]?

OP needs to figure out what he's doing. If he is indeed doing "normal" backdoor conversions, converting shortly after the TIRA contribution, then even the second 5-year rule is basically a non-issue, because the taxable portion of the converted amounts will be relatively small or non-existent. I mentioned the 5-year rule related to conversions to warn the OP that he should convert the TIRA contributions soon after making them, so that withdrawals are less complicated.

If he's making only direct contributions to Roth IRA, then he doesn't need to worry about the 5-year rules, and can remove the contributions at any time, tax- and penalty-free.

The idea is to make a lump sum $6K into a traditional IRA immediately for each person. Then to convert them into backdoor Roth ASAP [not sure how long it takes to actually do these things as I never done it before]. All investments would be in very safe assets until I have sufficient cash reserves to re-allocate the Roths to something more aggressive.

RE: Why do I need to do this vs. having enough to just do both now? Just graduated and am finishing paying off some other debt [will be done in December 2020]. Have prioritized clearing that debt over saving over the past few months, so in effect have very little cash savings currently. Given overall cash flow once debt is done, want to take advantage of 2020 Roth Contribution before its gone forever. Should have saved enough cash reserves in mid-to-late 2021 to re-allocate Roth to typical target portfolio and proceed as normal.

[tashnewbie]

The idea is to make a lump sum $6K into a traditional IRA immediately for each person. Then to convert them into backdoor Roth ASAP [not sure how long it takes to actually do these things as I never done it before]. All investments would be in very safe assets until I have sufficient cash reserves to re-allocate the Roths to something more aggressive.

Then I don't think you need to worry about the 5-year rule for Roth conversions. The ordering rules dictate that Roth withdrawals are done in this order:

1. Direct contributions (always tax- and penalty-free)
2. Taxable conversions (penalty-free after 5 tax years have passed from conversion tax year)
3. Non-taxable conversions (always penalty-free)
4. Earnings (tax- and penalty-free if you meet certain qualifications)

For you, #2 (taxable conversions) will be really small or nonexistent if you're converting TIRA balances shortly after funding them. In my experience with Vanguard this year, I was able to convert the TIRA balance 2 days after making the contribution, and there were no earnings during that time.

RE: Why do I need to do this vs. having enough to just do both now? Just graduated and am finishing paying off some other debt [will be done in December 2020]. Have prioritized clearing that debt over saving over the past few months, so in effect have very little cash savings currently. Given overall cash flow once debt is done, want to take advantage of 2020 Roth Contribution before its gone forever. Should have saved enough cash reserves in mid-to-late 2021 to re-allocate Roth to typical target portfolio and proceed as normal.

FYI: you have until tax filing deadline (standard is April 15) to fund the TIRA for the prior tax year. However, a conversion is reportable on your tax return for the calendar year in which it is done. So your taxes can get a little more complicated if you make a contribution for 2020 in 2021 and do the conversion in 2021, but it's not overly complicated or impermissible.

[humblecoder]

The 5 year rule is not applicable to direct Roth IRA contributions, which is what the OP is doing. I don't see the need for bringing up the 5 year rule and potentially confusing the OP.

In OP's original post, they say they will have to use the backdoor. Therefore, the other 5-year rule will be applicable. Maybe OP doesn't need to use the backdoor. If he doesn't and will only make direct contributions, then yeah, don't worry about the 5-year rules.

Non taxable conversions (i.e. Backdoor Roth) is not impacted by either of the 5 year rules.

[tashnewbie]

The 5 year rule is not applicable to direct Roth IRA contributions, which is what the OP is doing. I don't see the need for bringing up the 5 year rule and potentially confusing the OP.

In OP's original post, they say they will have to use the backdoor. Therefore, the other 5-year rule will be applicable. Maybe OP doesn't need to use the backdoor. If he doesn't and will only make direct contributions, then yeah, don't worry about the 5-year rules.

Non taxable conversions (i.e. Backdoor Roth) is not impacted by either of the 5 year rules.

Agreed, if someone is doing the conversions soon after making non-deductible TIRA contribution. I posted the ordering rules in my post directly above yours.

[grabiner]

OP needs to figure out what he's doing. If he is indeed doing "normal" backdoor conversions, converting shortly after the TIRA contribution, then even the second 5-year rule is basically a non-issue, because the taxable portion of the converted amounts will be relatively small or non-existent. I mentioned the 5-year rule related to conversions to warn the OP that he should convert the TIRA contributions soon after making them, so that withdrawals are less complicated.

For example, suppose that you contribute $6000 to a traditional IRA, then convert it as $6100, paying tax on the $100. If you withdraw in less than five years, you will pay a $10 penalty on the first $100 you withdraw, then no tax or penalty on the next $6000.

Since Vanguard brokerage accounts require contributions to go into the settlement fund first, I don't even bother to invest the money in my traditional IRA. I contribute it, put it in the settlement fund, and then convert a few days later, usually with less than a dollar in interest. This type of backdoor contribution makes the 5-year rule irrelevant, as the penalty on that dollar rounds to zero.