Using a Roth IRA as an emergency fund

The COVID-19 pandemic has really brought home for a lot of Americans exactly why it is so important to have an emergency savings account. Workers in travel, restaurant, hospitality and other industries are facing especially steep hits to their incomes. And we all face the harsh reality that it could take a long time for the economy to recover from the financial shock of the pandemic. 

Some of you who are now facing tough times may not even know that you already have additional emergency funds available to you if you have previously contributed to a Roth IRA. In fact, all of the money you contribute into a Roth IRA can be withdrawn with no penalty in most cases (withdrawal of earnings is taxable in most instances before age 59.5).¹ The availability of your contributions means your Roth IRA account can serve as a viable secondary emergency fund if things get dire for you and your family.

Penalty-free withdrawal of contributions

You’re probably aware that if you withdraw funds from a Traditional IRA or a 401(k) before age 59.5, you usually pay a steep price: You pay a penalty on top of paying income taxes on the entire amount you withdraw. Note: The Coronavirus Aid, Relief, and Economic Security (CARES) Act enacted on March 27, 2020, waives 2020 early withdrawal penalties for individuals who are diagnosed with COVID-19, those with a spouse or dependent diagnosed with COVID-19, or those who experience financial consequences as a result of the pandemic.

A Roth IRA, on the other hand, is different. You don’t pay income tax when you withdraw your contributions from Roth IRAs, as long as they are considered qualified, because you’ve already paid income taxes on that money before you contributed it to your Roth IRA account.¹ Now, granted, you do have to pay a penalty and taxes if you withdraw any earnings from your Roth IRA account. You’ll also pay a penalty if you make an unqualified withdrawal of earnings before you reach age 59.5 (unless you qualify for penalty-free 2020 withdrawals under the CARES Act), or before the account has been open for five years (whichever is later), but the amount you contributed is yours, without penalty.

When a Roth IRA withdrawal may be a good option

OK, we’ve established that you can withdraw the funds you’ve contributed into your Roth IRA without penalty. But should you? After all, the R in IRA stands for “retirement,” so it’s right there in the name of the account. And although it’s true that you should generally consider your Roth IRA to be a fund dedicated to retirement, a Roth IRA is a good option to use as a backup emergency fund.

So what do we mean by “backup”? Basically, the key is that we’re not suggesting you should use your Roth IRA as your main emergency fund. Don’t raid it when you have a flat tire or need a new clothes dryer. Having a Roth IRA does not cancel out the need for an easily accessible “regular” savings account for the day-to-day emergencies that everyone faces once in a while.

Instead, when you think of your Roth account as an emergency fund, you need to keep the mindset that it is your secondary emergency fund, to be used only in an all-else-has-failed situation. We’re talking about the really big, major financial crises – extended unemployment, a looming bankruptcy, a foreclosure or a large one-time expense related to an illness or other crisis. For some, the economic impact of the COVID-19 pandemic will create a major financial crisis, so it may be the right time to consider pulling out this “big gun” financially and withdrawing some funds from your Roth IRA.

You’ll need to consider if the risks of reducing your retirement savings are worth the temporary gain of having more available funds right now. If you’re ahead of the curve on retirement savings, a Roth IRA withdrawal could be a viable option. If you’re already playing catch-up on your retirement savings, you may be better off considering a personal loan to help you get through this while leaving your Roth IRA funds to grow for your retirement. If you’re not sure, you should talk it over with your financial advisor.

A personal example: my Roth emergency fund

The type of emergency in which you might use your Roth IRA as an emergency fund is the situation I was in when I learned about this option. Ten years ago, I was in treatment for cancer while my employer was undergoing a company-wide reorganization. I was worried about being laid off because I knew it was unlikely that my copayment-depleted emergency fund would last until I was healthy enough to find a new job.

When I had my annual meeting with my Roth IRA broker and mentioned this worry, he pointed out that I already had a robust emergency fund because I had been contributing to a Roth IRA for nearly 10 years. He reassured me that the part of my balance that represented my contributions was mine to use, free and clear, if I needed it.

The knowledge that I had a backup emergency fund was reassuring, so I’ve been contributing as much as I can to my Roth IRA every year since then. I’m simultaneously building my retirement savings and creating a financial safety net in case of a major crisis.

Roth IRA next steps

I talked to a financial consultant about the use of a Roth IRA as an emergency fund back-up, and he said that the flexibility of Roth IRAs is one of the reasons that he has recommended Roth IRAs to many of his clients over the years. The potential to use early withdrawals from your Roth IRA contribution amount to cover emergencies – or other financial needs, like college expenses – is one of the benefits of Roth IRAs. Saving with a Roth IRA gives you flexibility because if you don't need those dollars for emergency or educational needs, you just leave them in your Roth and any gains would be tax free.¹

He also asked me to emphasize that the IRS sets income limits for eligibility to open a Roth IRA, and recommends that whenever you’re considering making an investment in any account with taxable or tax-free consequences, you should always consult with your tax advisor.

1. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. While the information provided is based on our understanding of current tax laws, and has been gathered from sources believed to be reliable, it cannot be guaranteed. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor and with your financial advisor prior to investing. You can withdraw funds you contributed to your Roth IRA account tax- and penalty-free. Your Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply.  If you are younger than 59.5 years or if your account has not been open for five tax years (whichever is later), withdrawals of account earnings are subject to income tax and a 10% IRS early withdrawal penalty (unless your emergency is a qualifying event such as becoming permanently disabled). If your Roth IRA has been open for five tax years, distribution of $10,000 of your earnings to fund a first-home purchase is not subject to income taxes or early withdrawal penalties. If your account has been open for less than five tax years, the $10,000 first-home-purchase withdrawal is not subject to early withdrawal penalties, but it is taxable income. Roth IRA funds used for qualified educational expenses may be withdrawn tax and penalty free. Federal tax laws are complex and subject to change. Future tax law changes may impact the benefits of Roth IRAs as their tax treatment may change.