Emergency Fund or Roth IRA?
If you’re teetering on the edge of a trip down investing lane–but aren’t sure that you’re ready to begin locking money away–a Roth IRA just might be like two tickets to paradise. Pack your bags, we’ll leave tonight.
I just made that up. I know it sounds familiar. Deal with it.
Unlike its nasty cousin, the “For Retirement Only With a Couple Exceptions” Traditional IRA, a Roth has some attractive properties for people who need money in a safe place but are thinking “I’d like to start slipping some cash into a retirement account.” Two tickets to paradise.
Of course, this paradise has some weeds, but what do you want? I never promised you a rose garden.
Just made that up, too. I know…it’s a gift. Thank you.
Paradise Ticket #1: Emergency Fund
While it still makes absolute sense to have “need it right now” money outside of a Roth IRA, here’s the magical property that makes this shelter a fine second tier cash reserve emergency fund: you’re allowed to take principal back out whenever you want. If you remove funds contributed during the current year, it’s as if you’d never made a contribution in the first place. If it’s beyond the first year, you may take out up to the amount you’ve contributed.
That’s awesomesaucewithacherryontop because if you need money quickly, there’s no reason why you can’t access the cash you contributed.
Before you fight me on this, let’s work through it logically:
- When you make a Roth IRA contribution, do you receive any immediate tax benefit? No.
- How can the government penalize you for something that you received no benefit from? They can’t.
You want proof? Okay, here’s the IRS applicable document, Publication 590, Individual Retirement Arrangements. Check out the chart on page 63 and then the ordering rules on page 64.
More proof? At the bottom of the page I’ve included links to two less well written articles than mine. No charge.
When will you get into trouble? If you try and take any interest the account has earned, you’ll pay penalties to receive this interest unless it’s been in the account for five years and you’re 59 1/2 (whichever is later) OR qualify for one of the few exceptions to the penalty (you’ll still pay tax on the money when you withdraw it).
Paradise Ticket #2: Retirement
If you don’t end up needing the money, because your car didn’t break down, junior didn’t need to be bailed out of jail (again), and the dog stayed out of your neighbor’s trash bins for a change, this money can be used for retirement. At some point, once you’ve completely secured the reserve, you can switch these funds into more appropriate investments for retirement.
Ultimately, of course, this is what a Roth IRA should be used for: retirement savings. By easing into the Roth IRA plan, you’ll build the account early so there’s plenty of money available when you’re ready to begin in earnest.
Like Steve McQueen you’ll have a fast Roth IRA machine and they’ll never catch you tonight.
Oh, yeah, you weren’t thinking about having a Roth IRA as your only emergency fund, were you? A Roth IRA is, to put it bluntly, an absolutely rotten place for a first tier reserve.
Here’s just a sample of our problem:
- Remember when I said you can get money in a hurry? It’s not like the payday loan shop down the street or Louie on the corner. If your money is at an institution close by (like a neighborhood bank), you can probably take out funds now. If not, you’ll either have to wait for money to be transferred to a non-IRA account or until they can mail you a check. That’s not instant money. It’s “we’re going on an emergency trip to visit ailing Grandma in her cottage in the woods, and I paid for it with my credit card but don’t want to pay interest on the charge” money.
- If you take out all of your principal, you’ll only have some interest in the account. This money MUST stay in a Roth IRA for five years or until 59 1/2, which ever is later (as mentioned above). To take it out early, you’ll pay an IRS penalty. Although this may be a negligible amount on a small interest amount, it’ll make your tax return more complicated.
For these two reasons, I wouldn’t start a Roth IRA as your main emergency fund. Instead, only use it as second tier money.
What Type of Investment Should I Use, Joe?
It’s your cash reserve, silly. We don’t want to use anything that fluctuates at all. I know interest rates are poor, but if you’re only beginning, you’ll need the highest paying account the bank will allow while still keeping your money safe.
Don’t lock up the funds in a CD or you won’t be able to access the money, ruining why you used this strategy in the first place. It has to be a liquid account, like a savings account.
Once you have enough, transfer your money to a higher paying money market. Often this is between $500 and $2,000.
As soon as your cash reserve emergency fund is full, begin saving money into real retirement accounts that match your long term goals. Use a 401k for tax advantages today. Open a 529 plan for your children’s college.
Before long you’ll have so much cash they’ll be lining down the block just to watch what you’ve got.
How to Get Money In There Without Stealing It
The only way you’ll successfully save money is if you leave it outside of those pockets of yours. You know the ones. The I-can’t-hold-cash-for-longer-than-a-couple-minutes-without-spending-it pockets. Instead, make saving a bill.
Better yet, make it an automatic payment bill.
By setting up an automatic payment into your account you won’t have to remember to fund your account. Instead, money will flow directly from a checking or savings account into the Roth IRA, building it while you focus on other areas.
If possible, set up a separate direct deposit into your first tier reserve at your bank and then an automatic payment from the first tier reserve directly into the Roth IRA reserve account. That way, you’ll never have the money in your hot little hands.
If you want money in your hands AND to make Roth IRA contributions systematically, it’s going to be much harder, and there’s a good chance you’ll fail.
You can’t always get what you want. But if you set up an automatic payment plan you just might get what you need.
A Good Strategy
Once you’ve achieved your first tier reserve ($1,000 fast if you’re a fan of the bald dude on the radio, or other similar “quick cash” amount), split your automatic investment between your first tier reserve and a Roth IRA. This will help you ease into the investment world without the fear that the money is untouchable.
I’ve used this plan with nervous beginners to help calm them into rolling toward doing the right move: investing in their 401k where the money IS untouchable. It’s a good way to ease your mind.
…and before you know it you’ll be on your way to a million dollars. Then you could buy yourself a green dress.
But not a real green dress; that’s cruel.
No, I can’t stop.
Other Documents That Totally Agree With Me:
The Motley Fool: All About IRAs
My Money Blog: Can I Really Withdraw My Roth IRA Contributions at Any Time Without Tax or Penalty?
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