Opening a Roth IRA account is recommended for just about anyone who fits within the rules and who can afford to make a contribution. You can put in up to $5,000 per year ($6,000 if over age 50) of after tax dollars, and when you retire, start withdrawing all of the money in the account totally tax free. The biggest decision people have when they open an IRA is whether to open a Roth IRA account or a Traditional IRA account. (For a discussion of this decision, read Roth IRA vs. Traditional IRA.)
Withdrawal Rules under a Roth IRA
The Roth IRA withdrawal rules are different than those under a Traditional IRA. In a Traditional IRA, all withdrawals are taxable, both your own contributions and earnings. This is because you got a tax deduction for amounts you contributed into the Traditional IRA. Since this IRA gives you a tax deduction on contributions going in, the IRS wants their tax when you take the money out.
A Roth IRA, on the other hand, is not taxable when you take out money after 59 ½. You get no tax deduction when you contribute to a Roth IRA, and all money, both your own contributions and earnings, are totally tax free upon withdrawal after age 59 ½.
In a Roth IRA, there will be a tax, and penalty if you take earnings out, before age 59 ½. This rule is imposed so that people use the money to save for retirement. Your contributions to a Roth are always received back tax free since you have already been taxed on this money.
Tax Rules for Withdrawals form a Roth IRA
An interesting characteristic of a Roth IRA is the order of withdrawals. Let’s say you have an account balance of $1000 that consists of $700 of contributions that you put in, and $300 of investment and interest earnings. If you want to withdraw $500 because you have an unexpected expense and no other savings you can access, you are permitted to make a withdrawal from the Roth IRA. The question is: are you taking out your own contributions, or earnings or both under the tax rules?
The rules could have been written that the $500 withdrawal consists of $250 of the contributions that you put in, plus $250 of investment earnings. Had the law been written this way, you would have had to pay income tax on the $250 of investment earnings plus a 10% penalty if you took the money out before age 59 ½.
Fortunately for the taxpayer, the rules were written so that any withdrawals will first be considered as a return of your own contributions. After all of your contributions have been withdrawn, any additional withdrawals will then be considered as coming out of investment earnings. I do not know if the law was written this way on purpose or if it was an oversight. But who cares? The fact remains that you can take out your contributions whenever you want and leave your investment earnings in the account to be taken out tax free after age 59 ½.
In our $500 withdrawal example above, the IRS considers the entire $500 as a return of your own contributions. So, there is no income tax or penalties imposed no matter when you make the withdrawal.
Using a Roth IRA as an Emergency Fund
All financial planners and accountants recommend that you always have a savings account at your local bank with sufficient money to use in an emergency, and cover any unforeseen expenses. This is one of the first rules of financial planning. The amount you keep in the account is subject to opinion, but usually ranges between 3 to 6 months take-home salary. The purpose of this range is to cover normal monthly expenses in case the person loses his job and has no income coming in. The normal timeframe for an average person to find a new job is 3 to 6 months.
If a person remains employed, but has an unforeseen expense, such as a large medical expense not covered by insurance, then this fund can then be used for that purpose. After either a layoff or unforeseen expense, the first priority should be to build the emergency fund back up to where it should be.
People began to latch on to the fact that contributions can always be taken out of a Roth IRA tax free. Since many were contributing the maximum $5,000 per year, these accounts grew rapidly. So, if you have a Roth IRA that has a significant balance, say $50,000, why do you need an emergency fund in a saving account. Should an emergency occur, you can merely make a tax free withdrawal from the Roth IRA. A lot of people followed this thinking and just used their emergency fund for other purposes, such as a new car, a vacation, a new room on the house, etc.
The problem is many people did not stop to think if they should, in fact, use the Roth IRA as a cash emergency fund. Several points to consider:
- Is the money in the Roth IRA your primary savings for retirement? If the Roth is your primary means of saving for retirement, and not a supplement to some other retirement plan, you will be losing asset growth for retirement. Withdrawing principal will cause you to lose future investment earning on the amount withdrawn. If the unforeseen expense is large, you might even be risking your ability to retire when you planned.
- What is your Roth IRA invested in? Some people forget what type of investments they have in their Roth IRA. They may have invested the assets all in stocks and bonds or specialty mutual funds. If the Roth is used as an emergency fund, you may be forced to withdraw funds at exactly the wrong time, such as a down stock market.
- You cannot undo a withdrawal – if you make a withdrawal from a Roth IRA, you cannot simply put the money back in later on. Any contributions, either new or repayment of an emergency withdrawal, are subject to the annual $5,000 limit. If you have been making, and plan to continue making, the maximum $5,000 contributions, a large withdrawal can never find its way back into the Roth IRA. You will lose all future tax free growth on the amount withdrawn.
You should always have an emergency savings account for the unbudgeted expenses that arise each year. These might include washing machine finally gives out, new set of car tires, roof starts leaking, etc. While these may seem expensive items, they will occur each year and you should plan for them away from your retirement accounts.
If you want to use the Roth IRA as an emergency fund, make sure you use it only for true emergencies. Many people are not financially disciplined and once they make their first withdrawal from the Roth IRA, it is easy to make a second withdrawal. Once you make the second withdrawal, you begin to use the Roth IRA like your checking account. Then, when you reach your 50’s, you realize you have almost nothing saved for retirement.
For the disciplined, financially minded person, using the Roth IRA as an emergency fund can actually increase your overall financial situation. Your emergency money will grow tax free and if you don’t have any emergencies, the money will be an added bonus at retirement. This assumes, of course, that you do not go out and spend the amount in your current emergency savings account. You should invest that after tax money in other long term investments.