Using a ROTH IRA as an Emergency Fund

Deciding between building an emergency fund and saving for retirement can be a tough choice, especially for young adults just beginning their careers and creating their own personal financial paths for the first time.

There is no denying the need for an emergency fund in everyone's budget '" no matter how young or old you are, especially in these continued times of job uncertainty. Still, early deposits to retirement accounts can reap huge rewards later in life.

So, when there does not seem to be enough money for both, which should become a priority?

Thankfully, due to the ROTH Individual Retirement Account, it is no longer necessary to choose.

While many employers offer at least a limited match to employees who invest in a company's 401(k) plan, young adults who have yet to build an emergency fund should forego the benefit of a matching contribution for the time being and chose to invest their limited savings into a ROTH IRA.

Pre-Tax 401 (k) vs. Post-Tax ROTH

ROTH contributions are made post-tax, while 401(k) contributions are made with pre-taxed income. The primary reason for investing with pre-taxed income is to save on income taxes now with the assumption that you will be in a lower tax bracket once you reach retirement. That is not necessarily the case for young adults.

While it is impossible to accurately predict tax implications due to the government's ability to change future tax structures, it is quite possible that young adults currently employed in entry level jobs will enjoy lower tax brackets now than the ones they will see in retirement. While you will still owe tax on the investment earnings, a ROTH IRA gets the tax liability on the principal out of the way now.

How a ROTH IRA Can Act as an Emergency Fund

Because your principal contributions to a ROTH have already been taxed, if you need to withdraw money from the account for an emergency, you can do so without incurring income tax or penalty on the withdrawal of original principal. Again, if you also withdraw any previously untaxed earnings, you will incur a tax liability on those amounts.

If you are forced to withdraw emergency funds from a traditional IRA or a 401(k) plan, you may incur a 10% penalty in addition to a tax liability. This may not only reduce the amount you actually have available to cover the emergency, but may also wipe out any earnings benefit you have received on your investment to date.

How to Invest When Using a ROTH IRA as an Emergency Fund

If you are planning on using your ROTH IRA as both a retirement fund and an emergency fund, be sure to invest your savings in low-risk investments. These may include bank certificates of deposit, a money market fund, or short-term Treasury bills. Once you have built a sizeable balance or begin earning an income that allows for saving for separate retirement and emergency funds, you can convert your ROTH IRA investments into riskier investments with the potential for larger gains, such as mutual funds or publicly traded stocks. In the beginning, however, stick with safer, less volatile, investments. If you do, in fact, need to use your ROTH IRA savings for an emergency, certificates of deposit and money market funds eliminate the risk that you will need the money at a low-point in the market and have to withdraw the money at a loss.

True Emergency

Lastly, if you decide to temporarily use your ROTH IRA as an emergency fund, clearly define emergencies before temptations arise. Using a ROTH IRA as an emergency fund should only be done for true emergencies, not for vacations or other luxuries. Failure to make this critical differentiation, can lead to a needless deterioration of your future retirement funds.



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