Can Your Roth IRA be a Backup Emergency Fund?

I know many of you are working on building your emergency savings fund, and that it will take time to reach that goal. I am thrilled you are committed to this essential foundation of financial security.

At the same time, many of you are also contributing to a Roth IRA, which is also a fantastic move.  While the goal should always be to leave money in your Roth IRA growing for your retirement, it is absolutely understandable if you also think of your Roth IRA as your temporary “back up” emergency fund until you build up your actual emergency fund to the point it can cover a minimum of 8 months of living costs (I recommend to get it up to 12 months of living expenses to be safe though).

I want to stress it’s best to leave a Roth growing for retirement, but your Roth IRA can indeed be tapped for an emergency at any age.

If in a true emergency you need money, you can withdraw your contributions from your Roth without paying any tax, and without being hit with the 10% early withdrawal penalty that is charged when you make withdrawals from Traditional IRAs before age 59 ½.

I want to make sure you caught the important caveat there: it’s your contributions you always have access to, without tax or penalty. You don’t want to touch the earnings on what you have contributed— that’s money that can be taxed if you aren’t yet 59 ½ and you haven’t had the Roth account for at least five years.

For example, let’s say over the years you have contributed $12,000 to your Roth IRA, and it now has a value of $16,000. In an emergency, you could withdraw up to $12,000 with no tax or penalty. It’s the $4,000 in earnings you don’t want to touch if you aren’t yet 59 ½ and have had the account for five years.

Now, if you are currently thinking of your Roth IRA as your back up emergency fund, we need to make sure it is invested correctly. Money that you might need as an emergency must be kept in cash. If your Roth IRA is at a discount brokerage, look for the money market mutual fund. Every brokerage offers at least one. That’s where you must keep money you might need to tap. Not stocks. And not bonds. Only cash.

Yes, I know money market mutual funds don’t earn any interest right now. That’s frustrating, but it is still the right investment. Because here’s what you need to focus on: you never know when an emergency will arrive. And if your Roth IRA is invested in stocks, right when you need the money, the value of your account could be way down.

For example, if you had your Roth IRA invested in U.S. stocks, your account value fell around 35% when the coronavirus bear market struck in February and March. What if you got laid off then and needed to tap your account? If you had $10,000 before the bear market, it had fallen to $6,500 by late March.

That’s why I want anyone who is using their Roth IRA as a backup emergency fund to keep the money in a money market mutual fund. Once your regular emergency fund is big enough to cover 8-12 months of living costs, you should then move your Roth IRA account into stocks to build up your account for your retirement years.

If your Roth IRA is worth more than what you need to round out your regular emergency savings, you can think of your Roth IRA account has having two pieces. Keep some of it in the money market mutual fund to bring your overall emergency savings to at least 8-12 months of living costs. And then whatever is left over can be invested for long-term growth.