How to Hack Your Roth IRA as an Emergency Fund

Don’t emergency funds suck?

Sure, they might help you sleep better at night. But let’s be honest. In the world of putting your money to work, that lousy emergency fund is the biggest slacker in the group.

While the rest of your money is busy wheeling, dealing, and investing, that boring emergency fund is just lounging around, waiting for something bad to happen. And like the lazy kid who won’t leave mom’s basement, your emergency fund is probably costing you $800,000.

Wouldn’t it be great if you could convince that lazy bum to start pulling double duty?

More specifically, wouldn’t it be great if you could save for retirement and build your emergency fund, at the same time?

And wouldn’t it be even better if you could access that retirement money, tax and penalty free, whenever you wanted?

Good news! You can!

Here’s how to do it.

The Roth IRA’s Super-Secret Emergency Weapon

One of the most overlooked features of the Roth IRA? You can use it as a secret emergency fund, in disguise.

According to IRS Publication 590:

You don’t include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s).”

Let me translate that from robotic tax code to regular human speech:

You are always allowed to withdraw your Roth IRA contributions, whenever you want, tax and penalty free. 

Pretty sweet, right?

Logically, it makes sense. Remember, Roth IRAs are funded with after-tax dollars. Since Uncle Sam already got his cut, you won’t need to pay taxes again. And because a big tax benefit of an IRA is tax free growth, you’re free to withdraw the portion that hasn’t grown.

Which leads us to the catch…

What’s the caaaatch?

The important distinction is that if you want to hack into your Roth IRA without paying taxes or penalties, you can only withdraw your Roth IRA contributions. Not the earnings.

If you start dipping into the account’s earnings, the IRS is gonna hit you with your usual tax rate, plus the 10% penalty for withdrawing retirement money before age 59.5.

A quick example to drive the point home. You’re a 25-year-old Money Wizard-reading genius. In your first two years out of school, you contributed $5,500 each year to your Roth. Go you!

You’re pleased with your $11,000 of Roth IRA contributions, and you’re even more pleased that the value of that account increased to $15,000, thanks to your savvy choice of index funds.

Then, WHAM!

Aliens crashing out of the sky. And they cause enough damage that you start looking into hacking your Roth IRA as an emergency fund.

In our example here, you can freely withdraw $11,000 to bribe yourself free from your new alien overlords. BUT, if you tap into the Roth’s last $4,000, you’re now into dipping into the land of Roth IRA earnings. The IRS will tax that $4,000 as ordinary income and slap you with a $400 early withdrawal penalty.

Advantages of a Roth IRA Emergency Fund

So far, as long as we stick to our contributions, our Roth E-Fund is looking like a pretty sweet deal.

Let’s be honest. The typical emergency fund advice is the investment equivalent of burying your cash in the backyard, then allowing it to be eaten away by the worms of inflation and opportunity cost. Using the Roth hack, a savvy investor can use their IRA to:

• Build retirement savings
• Prepare for an emergency
• AND enjoy tax advantaged growth.

But before you start tapping into your Roth to pay for an unexpected oil change, we need to consider something important.

The Biggest Negative of a Roth IRA Emergency Fund

By IRS law, you’re not allowed to contribute more than $5,500 to your Roth each year. That limit is set in stone. Once the deadline is up, you can never make up for previous year’s lost contributions.

This also means that when you withdraw your Roth contributions, you’re setting your retirement savings back a few years.

In our alien overlord example, withdrawing $11,000 of contributions is essentially setting your Roth savings back by two years. And since the $5,500 annual contribution limit is set in stone, you can never contribute extra to make up for your temporary emergency. Instead, you’ll have to spend two years building the balance back up, which also means you’ll lose two years of investment returns on whatever amount of money you withdrew.

So, who should use a Roth IRA as an emergency fund?

It might actually be easier to start with who shouldn’t use the Roth IRA Emergency Fund:

The Retirement Non-Saver: If someone’s Roth IRA represents their one and only retirement plan, tapping into the account is obviously a bad idea.

The Person Who Uses Their Emergency Fund For Every. Little. Thing. Constantly pillaging your retirement to pay for routine groceries and car maintenance is a losing battle. In fact, constantly dipping into an emergency fund is usually a symptom that you’re living dangerously near paycheck to paycheck. If that’s the case, go ahead and close this article now.

To successfully employ the Roth IRA Emergency Fund strategy, your emergency fund needs to be reserved for extreme emergencies. We’re talking those life altering disasters that aren’t covered by the large savings rate built into your usual monthly budget, the insurance policies you carry, or the leftover cash in your couch cushions.

The Ultra-Risk Averse Investor:  Make no mistake, investing your emergency fund is riskier business than just stashing cash in coffee canisters.

The textbook concern is losing your job, which tends to coincide with downturns in the overall stock market. If this thought completely freaks you out, you may want to stick with more traditional advice.

But before you totally abandon the idea, do remember that your IRA doesn’t have to be invested 100% in the stock market. Your IRA account can also invest in safe options, like bonds, money market funds, or even a boring old savings account. Plus, you’re free to change the allocation whenever you want.

Who could benefit from a Roth IRA Emergency Fund?

The Early Journey, New Investor: For the cash strapped new investor, the Roth does a decent job of killing two birds with one stone.

Imagine the scenario where a new investor takes the traditional advice. They sit on the sidelines building up hordes of cash. During that time, maybe a year or two goes by, and they miss that year’s opportunity to make maximum contributions to their Roth IRA, forever.

Now let’s say they instead built that emergency fund by contributing to their Roth IRA. Chances are, they won’t actually run into an emergency needing them to withdraw on their contributions.

And even if they do, so what? They lose their Roth contributions… but had they followed traditional advice, they’d have been too busy stockpiling cash to ever make those contributions in the first place! Plus, the account still keeps the tax free earnings.

The Advanced Investor: At some point in your investing journey, you’ll find yourself in a pretty amazing position. You’ll have money in all sorts of assets, and the lack of a big cash pile won’t bother you in the slightest.

Who needs thousands in cash, when you have hundreds of thousands between stocks, bonds, home equity, 401ks, and IRAs?

A different way of viewing Emergency Funds

I still consider liquid assets the ultimate emergency fund. But the flexibility of the Roth IRA highlights an important point.

Once you reach a certain level of financial wizardry, your emergency fund doesn’t have to be this rigid, boxed off section of your portfolio.

Building towards financial independence is all about building layers upon layers of security. Just like we build multiple streams of income to diversify risk, it’s perfectly okay to view your emergency fund as spread out across all your assets.

In that way, the Roth IRA emergency fund serves as a pretty awesome feature.

Look, I’m not saying your retirement savings should be your only emergency plan. I’m saying that a Roth IRA can serve as an often overlooked money source if things get totally wheels-off disastrous.

Personally, I like to consider my Roth IRA as an extra layer of security in my overall emergency funding strategy:

1) At the first layer, I intentionally live below my means, which means I pay for any unexpected bills just by saving a little bit less than normal.

2) Next, I have the spare change in my checking account. Usually, this is the income left over after the credit card bill is paid, and before I’ve moved the money into an investment account. (Typically totals a couple thousand dollars.)

3) Then, I have plenty of liquid assets. My $100,000+ of index funds could be sold, deposited into my checking account, and withdrawn as cash in my hand in 3 days or less.

4) And right behind that, sits my Roth IRA. Silently, secretly, and super stealthily acting as the world’s most underrated emergency fund.

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