This article is by GRS contributor William Cowie.

Life is full of little bumps … like how our furnace went out at the onset of last season’s most severe cold snap. It’s bad enough that an emergency like that seems to happen at the most inopportune time, but what’s worse is the $6,000 bill that accompanies it. Where do you get $6,000 quickly when you need it?

If you’ve set money aside for a rainy day, you’ll be less likely to go into debt — or to tap your retirement funds — when the bill comes. But recently, I heard Suze Orman advocate using your Roth Individual Retirement Arrangement (Roth IRA) as your emergency fund in a public television fundraiser broadcast.

Like many here at Get Rich Slowly, she is a big fan of emergency funds. However, the concept of using your Roth IRA as the primary vehicle for your emergency fund is something we have never addressed.

Cracked nest eggThe purpose of an emergency fund

We might all agree that the purpose of a well-funded emergency fund is to help you meet unexpected events without going into debt, but the question of how much to save is a topic of endless discussion … and virtually no agreement. Some say three months’ worth of expenses; Ms. Orman recommends 12. Whichever amount you feel is sufficient, it usually is not trivial.

And neither is the amount you want to set aside for your retirement. It’s easy to see where the temptation may arise to combine the two, as Ms. Orman (and others) recommend. But should you?

Should you use a Roth IRA as an emergency fund?

There are a number of reasons why using your Roth IRA as a vehicle for your emergency fund is a bad idea:

1. Penalties. Think twice if you read a blog that glibly states that you don’t incur a penalty when you withdraw from your Roth IRA for an emergency. That’s wrong.

It may sound true in theory that the actual contributions you withdraw are not penalized. However, you’re rarely able to pull that off in practice.

  • Example: Let’s say you’ve contributed $40,000 to your Roth over the years, and it’s earned another $10,000, bringing the total in your IRA to $50,000. Now, let’s say your furnace went out and you want to withdraw $6,000. You say, “Hey, I’ve put in way more than that, so the $6,000 I’m taking out is only from my contributions — I don’t need to touch any of the earnings.”

Not so fast.

The IRS and tax people call the money you put in (your contributions) “basis.” In other words, you say that you’re only withdrawing basis for your emergency — but the IRS doesn’t see it that way. When you take out the $6,000, they look at your IRA at the time and say 20 percent of the total ($10,000) is earnings and 80 percent (the original $40,000) is basis. Whenever you make a withdrawal, they deem 80 percent of the withdrawal to be basis and the other 20 percent as earnings.

You don’t get to determine what is basis and what is earnings; they do. And they will penalize you on the portion of your withdrawal they consider to be earnings. So while, in theory, it may be true that you won’t be penalized on your basis which you withdraw, it rarely works out that way in practice.

The topic of penalties on early withdrawals is complex and you will definitely need to see a tax professional to know if using your Roth IRA as an emergency fund makes sense. As a rough guess, though, that won’t be true in more than about 10 percent of all cases. For the final word on the rules and intricacies of Roth IRA withdrawals, please consult the definitive IRS source.

Don’t just accept it when bloggers make glib statements like “tax-free in /tax-free out.”

2. The time guillotine. You can only contribute $5,500 a year to all your IRAs combined (Roth and traditional). It’s $6,500 if you are 50 years of age or older. Once every year’s deadline passes, the guillotine comes down on that year’s contribution and you can never make it up afterward. As we pointed out in The extraordinary power of compound interest, the key to success when investing for your retirement is to start early, and so it is vital to contribute as much as you can as early as you can to get those contributions on the other side of the guillotine — and to keep it there so your money can keep compounding.

When you make a withdrawal from your Roth IRA to fund an emergency, you have only 60 days to replenish it. After that, the guillotine comes down on that amount and you cannot put it back. If you are able to replenish your Roth IRA withdrawal in less than 60 days, of course, this is not an issue. But if you can, why not simply use the replenishment for the emergency in the first place?

3. Economic cycle. Everyone knows that while most Roth IRA investments grow in the long run (like index funds do), they always fall victim to the downdrafts which the economy experiences every seven to 10 years. What if you needed access to your emergency fund at a time when your Roth IRA investments were at a low? You’d be forced to sell your investments at a loss.

Some advocates of using your Roth IRA as an emergency fund counter that you should keep that part of your IRA in a money market fund to guard against a loss like that. But why? The return on those accounts is minuscule and you would be hard-pressed to discern a difference between tax-advantaged and not. You might as well keep that money in a regular account without any attempt to gain a tax advantage. Remember, you can only contribute $5,500 a year to your IRA. Why use part of that for something with no return? Far better to utilize that entire amount for investments which grow over the long term.

4. Psychology. One of the keys to success in investing for retirement is to forget about it. Put the money in before you consider spending it, in other words. Withdrawing money from your retirement fund is a slippery slope: Once you start, it becomes very hard to stop.

5. Liquidity. When an emergency strikes, you need to get access to your money fast. Few Roth IRA accounts will return your money within 24 hours — which isn’t helpful in an emergency, to say the least.

It seems like it would be a better idea to find another vehicle for your emergency fund.

Where to save your emergency fund

The first attribute of a good emergency fund is liquidity — as in, you need to get at these funds within a few hours. The second attribute is safety, meaning it can’t be tied up in an asset that could fluctuate in the short run, causing it to be under water when you need to make that quick withdrawal. There are a few alternatives which pass the liquidity and safety tests:

1. Your mattress. It may not be politically correct to say this these days, but few options beat your mattress for liquidity. Another reason to keep at least a couple of hundred dollars in cash somewhere in your home? When a disaster strikes and power goes out, you may find that the stores and other places you could ordinarily process debit or credit cards — and/or your friendly ATM — may be out of power (or out of cash).

2. Savings account. In my opinion, the lowly savings account is by far the best place to store most of your emergency fund. The deposits held in an ordinary online savings account are protected against bank failure by the FDIC, and you can get quick access to your money whenever you need it. Most online savings accounts allow you to transfer the money to the account backing your debit or credit card, so you can usually pay for what you need within minutes.

3. Certificates of Deposit (CDs). A CD usually pays more than a savings account. Granted, you still need a microscope these days to tell if you earned any interest — but every little bit helps, as my wife likes to point out. For higher liquidity, no-penalty CDs are available, or you can ladder your conventional CDs to greatly increase liquidity. And, of course, CDs are protected by the FDIC too.

4. Prepaid credit or debit card. This is handy, especially for travel emergencies. If your first stop after an emergency is a hospital, you don’t have time to access savings accounts and things like that. Having a prepaid card handy will often take care of your immediate needs, giving you time to mobilize your second and third lines of defense.

Your best emergency fund strategy

The downside of the four suggestions above is they pay no interest, or close to nothing. When you look at the gamut of emergencies against which the fund is meant to protect, you find that, as the amounts increase, the probability you’ll need that entire amount decreases. For instance, if you lose your job, you’re not going to need all 12 months of your emergency fund right away.

The longer you tie your money up, the more you get in terms of interest. That being the case, you might want to consider various layers of funds for your emergency fund money:

  1. A few hundred dollars in cash for really quick access in case of a power emergency
  2. A few hundred dollars on a prepaid card
  3. A bigger chunk in an online savings account or no-penalty certificate of deposit.
  4. A chunk in conventional CDs, laddered for staggered maturities.

Which proportions should go into each account will depend on your situation and the emergencies for which you are preparing. In addition, take into account that interest rates are expected to rise in the coming years.

Keep in mind that your Roth IRA will always remain in the background as a final if-it-comes-to-that source of money for seriously big emergencies. However, as regards using your Roth IRA to house the bulk of your emergency funds, the downsides seem to outweigh any pluses.

Any consideration of the use of a tax-advantaged vehicle like a Roth IRA is likely to be more complex than you might think, especially because Congress keeps changing the rules. What you read two years ago is probably out of date in some respect. But regardless, if you must consider using your Roth IRA as an emergency fund, it’s best to consult a tax professional.

The far better route is to use simple, easy-to-use and easy-to-understand financial products like an online savings account, a CD, or both.

What are your thoughts? Do you use your Roth IRA as an emergency fund? How do you accommodate for the potential that you might have to sell at a loss? Is it ever a good idea to think of your Roth IRA as your emergency fund?

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