Roth IRA as Emergency Reserve?

Question: I was wondering what you think about using a Roth IRA as a “true” emergency reserve (job loss, etc.) vs. a cash reserve for “stuff that just comes up” (water heater breaks, fender bender, etc.).

You could draw down the principal of the Roth tax-free, and if you invest in TIPs [Treasury Inflation Protected Securities], there shouldn’t be too much volatility and at least you’re not falling behind inflation before taxes. Once you hit your reserve goal based on contributions, excess contributions, earnings, etc. could be invested in equities.

Answer: For those who are eligible to contribute to a Roth IRA, your thoughts make good sense. While a Roth gives no immediate tax deduction, all of the earnings grow tax-free and can then be withdrawn tax-free so long as the withdrawals occur no earlier than the calendar year in which the taxpayer turns 59 1/2. But the contributions themselves can be withdrawn any time, even the day after making them, with no tax consequences whatsoever. So if someone under 50 makes the maximum allowable contribution, $5,500 for 2016, that entire $5,500 can be withdrawn for any reason without taxation. Moreover, if the money is rolled back into the Roth within 60 days, it can then continue earning tax-free income and be available for another 60-day rollover after more than a year (365 days, not calendar) has passed since the last such temporary withdrawal. Once 60 days have passed since the withdrawal, however, it is permanent, and those funds cannot be returned to the Roth. Given the extraordinary benefit of long-term tax-free income on otherwise taxable money, it is best to move heaven and earth to return the funds within 60 days (and to not violate the requirement of waiting 12 months since the last rollover before doing another one).

When I started saving after college graduation, well before Roth IRAs were introduced, I had to go through the internal debate on where to put my first dollars of savings. I wanted to have a cash reserve for emergencies as well as put money into my IRA to gain the multi-decade benefits of tax-sheltered growth. But I also thought it would be nice to spend some money on extravagances such as food, rent, utilities, and transportation. Today, someone starting his or her savings program doesn’t have to make that choice, thanks to the Roth. So an A-plus for this reader’s thinking.

Now, let me add a few details and additional thoughts. Not everyone can contribute to a Roth IRA. The tax rules change periodically, and numbers are indexed for inflation, so don’t rely on this post for the current rules. (I suggest the reference room at Kaye Thomas’s excellent tax-help site.) In 2016 a married couple filing a joint return needs to have adjusted gross income of less than $184,000 to make the maximum allowable contribution for each spouse ($5,500 for those under 50 and $6,500 for those over) and single filers need to have adjusted gross income under $117,000. The maximum contribution phases out between $184,000 and $194,000 for the former and between $117,000 and $132,000 for the latter. Oh, and you need to have earned income (which includes wages, self-employment income, and alimony). There is a little trick possible if you go over the limits and have no IRAs, allowing you to make a nondeductible contribution to the traditional IRA and then immediately roll it over to the Roth. (It gets more complicated and costly if you have balances in traditional IRA accounts and is likely not worth the hassle.)

So I do suggest that your first dollars of savings go into the Roth IRA. And I’m not so sure you need to be afraid of volatility. Sure, if your only emergency funds are a single contribution to a Roth IRA made on the very day a bull market peaks and you need all the money on the very bottom day of the bear market that follows, you’ll regret having invested it in the market. But if you’re adding gradually with monthly contributions to build up the reserve, that isn’t going to happen, and if you use one of the Modern Portfolio Theory equity funds, such as the iShares MSCI All-Country World Minimum Volatility ETF I’ve mentioned before, you’ll have significantly higher expected returns with below-average market risk, which, over years of compounding, will make a very big difference for funds that are only being reserved for a hypothetical emergency that could occur at any time in your investing life. I personally think it makes sense to invest the Roth assets for long-term growth in any event.

Build up cash in taxable accounts as your ability to save grows beyond the annual Roth contribution limits, since extra earnings do you less good in accounts subject to annual taxation, and you are far more likely to draw on cash when the hassle is smaller. Sometimes emergencies are exaggerated to spend unnecessary amounts (such as replacing a car that could have been repaired), and having the funds invested for growth in a Roth IRA might reduce the tendency to overspend based on the “emergency” excuse.

Still, I return to the short answer: a big thumbs up on saving the first dollars in a Roth IRA, if eligible, even when those dollars are being reserved for emergencies.