Today’s question was posted by Sandee in our HTM Facebook Group page…
“Question about using your Roth IRA as an emergency fund…
I’ve often heard that your contributions (if you were to withdraw them pre-retirement for an emergency, for example) are not taxed.
However, someone else told me it’s only if the money is still in the settlement fund. Once you use the money to purchase funds to invest in, any amount you remove early from selling some of that stock is subject to tax. Is that correct?
Right now I keep my emergency savings in a high-yield savings account. But should those savings interest rates drop like they did a couple of years ago, I might consider using my Roth IRA as a place to park my emergency account.
I just want to make sure I know the rules if I need to withdraw from that Roth account.”
Matt & Joel’s response: This question opens a lot of threads. Even though you are allowed to withdraw Roth contributions, is it the right money move? Should people use their Roth IRA as an emergency fund?
We’ll do our best to help!..
Roth IRA withdrawal rules
First off, Sandee, what you were told ain’t true.
All original contributions to a Roth (no matter if the money is invested in funds or sitting in cash) are available to withdraw at any time, for any reason, without taxes or penalties.
For example, let’s say you put $5k in your Roth a decade ago, and invested it in a total stock market index fund. And now it’s worth $12k because of 10 years of market returns… You can sell $5k worth of that fund, and pull it out of your Roth account without incurring any penalties or taxes.
When it comes to the account growth and any dividends though, this money needs to wait until age 59 ½ to be withdrawn without issues.
Is it a good idea to withdraw money from your Roth IRA?
We love how flexible Roth IRAs are.
Being able to pull out original contributions is clutch. It means your retirement funds aren’t “locked up” until age 59½. That’s perfect for early retirees or folks who need to use that tax-free money sooner.
But it’s dangerous to take funds out too early! Too many Americans rob their retirement funds, and then reach older age without having enough saved.
Emergency or not, we recommend everyone keep their retirement funds invested for decades in order to maximize growth and take advantage of compound interest.
The money you pull out is like putting those dollar bills on unemployment. You’re making one of the biggest investing mistakes, which is interrupting compounding unnecessarily.
Roth IRAs are your best friend in retirement
Having a sizable Roth IRA later in life can give you wicked flexibility when it comes to retirement withdrawals.
All the money you pull from your Roth IRA after age 59½ is tax-free. So using this to supplement your regular retirement income doesn’t add to your tax burden.
In fact, you can use your Roth IRA to reduce your tax burden a little. By withdrawing Roth funds instead of traditional IRA or 401k accounts, you can lower your income tax burden a little within the years you do this.
It’s hard to fathom what life will look like in 30, 40 or 50 years time. But I promise, you’ll want more options, not less! Having a healthy blend of Roth and traditional retirement funds gives you that ultimate flexibility.
Backup emergency fund
While it’s not a good idea to completely rely on your Roth as an emergency fund, I do think it’s totally fine to think of it as a backup emergency fund. Like if 💩 really hits the fan in life.
If you’ve got 3-6 months of living expenses in a regular emergency fund, but life throws you a ridiculous curveball that threatens your entire livelihood, it’s OK to tap your Roth. That’s why those rules are in place.
And actually having a Roth can even help you lower your emergency fund just a little… For example, if you currently have a 6-month emergency fund in an HYSA, you might be able to reduce that down to 3 or 4 months’ worth of savings, knowing you have a mammoth Roth to tap if needed. It’s a happy medium approach.
A robust amount of Roth IRA contributions can allow you to be a little riskier on the savings side. But liquid cash is always a necessity.
The Bottom Line:
You can withdraw original contributions from a Roth IRA at any time, for any reason, without penalty or taxes. The issues come only if you withdraw investment growth or dividends before age 59½.
But, just because you can withdraw Roth funds easily, that doesn’t mean you should! A Roth IRA should not be your emergency fund! It’s an account for long-term retirement investing. The longer you leave money in that account, the more you’ll maximize those tax benefits!
Make sure you always have liquid cash for an emergency fund. We recommend 3-6 monthsof living expenses, depending on your specific situation, to cover both big and small emergencies.
Good luck Sandee! Happy investing!
For the full version of this discussion, check out Podcast Episode #814 (it’s the second to last question we answer in the episode)
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