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One tax-advantaged account gives you more options for accessing your money in a pinch.
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You never know when life might throw an unpleasant financial surprise your way. You could get into your car to find that it doesn’t start, or wake up to a freezing cold shower thanks to your busted water heater.
Or, you could end up losing your job if your employer is forced to downsize. That could mean living on a measly unemployment benefit payment until you’re gainfully employed again.
That’s why it’s so important to have money set aside for financial emergencies. And the best place to keep that money is a savings account, where you’ll have easy access to your cash at all times.
Meanwhile, a retirement savings plan is generally not a good place for your emergency fund. That’s because there can be steep penalties for tapping a tax-advantaged account, like an IRA or 401(k), before reaching what’s considered retirement age.
But one specific tax-advantaged account can technically double as your emergency fund. Whether it should, however, is a different story.
You can tap your Roth IRA in a pinch
The reason the IRS penalizes you for taking an early withdrawal from a tax-advantaged retirement account is that you’re supposed to be saving that money for your senior years, and you’re getting a tax break to encourage you to do just that. So if you remove funds from one of these plans before age 59 ½, you’ll generally be penalized to the tune of 10% of the sum you remove. If you tap a traditional IRA because you’re in a jam and withdraw $10,000, you’ll lose $1,000 as a penalty.
But Roth IRAs work differently. With a traditional retirement plan, you get a tax break on the money you put in, but then pay taxes on withdrawals during retirement. With a Roth IRA, there’s no tax break on your contributions. Withdrawals, however, are tax free.
Because you don’t get an upfront tax break on the money that goes into a Roth IRA, you’re also not penalized for taking early withdrawals. That assumes, however, that you only touch your principal contributions, not your gains.
If you put $20,000 of your own money into a Roth IRA and it grows to $30,000, you won’t be penalized for withdrawing your initial $20,000. But penalties will apply to that $10,000 gains portion.
Why it pays to leave your Roth IRA alone
While you can take a Roth IRA withdrawal in the event of a financial emergency, doing so could put you in a position where you wind up cash-strapped later in life. Even if you’re not penalized for taking that withdrawal, you’ll be penalizing yourself by removing those funds so they’re not available to you at a time when money may be even tighter.
Remember, too, that when you take money out of a Roth IRA, you can’t invest it. And so you lose out on the chance to grow it into a larger sum in a tax-advantaged manner (since investment gains in a Roth IRA are tax free).
That’s why it’s not the best idea to rely on your Roth IRA as an emergency fund — even though it can technically serve as one if you need it to. Instead, do your best to pump money into a regular savings account and tap that account when unplanned bills creep up on you. Doing so could help ensure that you don’t run into financial difficulties during retirement, and that you’re able to make the most of your Roth IRA by investing your money and letting it grow.
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