Roth IRA Contribution vs. Emergency Fund Savings

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Earlier this week I explored how the performance of money invested in a 401(k) should compare to a regular brokerage account. This brought to mind a different debate:

If you had to choose between contributing $4,000 to a Roth IRA or keeping/putting it towards your Emergency Fund, which would should you choose? We’re assuming you don’t have the funds to do both. Many people put Emergency Fund near the top of their priority lists, just below taking advantage of any “free money” 401(k) match, but above all other retirement accounts. This is because you don’t want to have to dip into retirement accounts and face stiff penalties, or otherwise be faced with other forms of high interest debt like credit cards or personal loans if you need money urgently.

However, the annual $4,000 Roth IRA contribution limit is a “use it or lose it” proposition. You can’t put nothing in this year, and then $8,000 the next. Once April 15th rolls around, you’ve missed out on potential tax advantages that may extend several decades (even to your heirs). This may be mitigated somewhat if you also have a Roth 401(k) or other similar account available.

I used to be in the Emergency Fund First camp, but now I think I’ve changed my mind, mainly thanks to commenter Jbo. Here’s my reasoning. Let’s say you go ahead an contribute $4,000 to a Roth IRA but leave it invested in something safe like a money market fund. Many banks also allow you to open IRA accounts holding certificates of deposit. Now, there are basically two possible resulting scenarios after you do this:

You end up needing the money
No problem, you can always withdraw your Roth IRA contributions without any penalty. Just take out what you need (up to $4,000), and leave the rest in the account. Since it’s in a safe investment it won’t have decreased in value due to stock market volatility. You’ll still lose the tax advantages on any withdrawals, but you’d have missed out anyways.

You don’t need the money
More likely than not, you won’t need all the money, and hopefully within a year or so your emergency fund will be replenished from other sources. Now, you can start really taking advantage of the Roth IRA’s tax benefits and move to riskier investments.

Using the same assumptions as before, a $4,000 post-tax Roth IRA contribution would theoretically end up being worth $40,251 after 30 years. If the $4,000 was placed in a taxable account, you’d only end up with $32,834. Even if you assume inflation will run 3% a year, that’s still $3,000 more in today’s dollars that you made on your initial contribution of only $4,000 by putting it in a Roth.

Am I missing anything? It would seem like putting money in the Roth IRA is a pretty safe bet. The downside is very small, and the upside is very high. One key thing to remember is to keep the Roth IRA money in a safe investment while you are treating it as a emergency fund, as stocks have been known to drop as much as 40% in one year. You don’t want to be having to sell your stocks to get cash after that happens!

  • Make sure your current IRA is charging you as little in fees as possible.  Visit and their IRA wizard for a quick look into the best discount brokers offering IRA’s.
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  1. Great post! A few things to consider:
    1. Should you go with the money market for safety reasons, or go with a more aggressive approach assuming that you may never touch the money? Maybe something in between, like a balanced appoach.
    2. If the person goes with the money market approach and eventually doesn;t need the Roth money for an emergency, they will need to be diligent and remeber to re-allocate the money to something that falls in line with their retirement time horizon.
    3. Don;t forget about the other reaons you can take the earnings out. Like first time home purchase.

    Awesome blog!

  2. Heresy!

    I do see your point though. However, one thing I like about my emergency fund is that I have a checkbook for it. (I also don’t favor the “laddered CD” approach to an emergency fund because I want liquidity). So if I need to get the money out, it’s straightforward. How much of a time delay would there be extracting money from a Roth?

  3. Your assumptions make sense, and I agree that a Roth is the best solution to maximize after-tax returns, but consider this:

    If a person only has exactly enough to cover the $4k, will he/she be expected to have enough to also fund the Roth and a separate emergency fund the next year and years after? We can assume that the person’s income will increase, but the Roth contribution limits will increase as well. In Year N they will find themselves in the same situation as Year N-1 unless their income increases at a rate faster than their expenses and the Roth contribution limits. For people who are living the most on-edge (i.e. paycheck to paycheck) and who truly need an emergency fund the most, they would need something to get them over the limit where they could have both a Roth and a separate emergency fund. Using a Roth as an EF is only a stopgap measure, as it is intended to be a retirement savings vehicle. Removing your contributions from the Roth will significantly impact your retirement savings, much more so than spending some money in a taxable account, as you illustrate in your example. And, likewise, if you limit your Roth to a money market fund because it is being used as an emergency vehicle, it will similarly impact your retirement savings.

    However, a person who was fresh out of school, or still in college, or expecting some kind of substantial salary increase would probably be better off putting their $4k earned income towards the Roth in lieu of a separate emergency fund, because they will expect to have a substantially higher income in the near future, and then could have both a Roth (in stocks) and a regular (taxable) emergency fund in a money market or savings.

  4. You can only withdraw it if you have had a Roth IRA for five years.

  5. Completely agree with you Jonathan – exactly how I view it. Although I don’t know how easy it is to pull out, if you could only save $4000 a year, I’m not sure if you would actually need a separate emergency fund at all. After 3 years lets say, you could put the entire amount (12k) into stocks, and even with a 50% drop, you’d still have 6k in principal to pull out if you need it.

  6. Yes, I totally agree with this. And if I had an extra $4K, it would go to a Roth and not my savings account. But I’m a person who doesn’t keep an emergency fund — when a real emergency happens, I’ll take my lumps and pull out money from my retirement instead. Between needing the money and getting that money I can lean on a credit line I have at my bank plus any credit card checks (with the lowest possible interest). I’m paying a premium for emergency liquidity, okay, but I don’t have a problem with that. I’d rather be socking away the maximum possible into my retirement and hope for the best.

    However, if I were to accumulate any additional savings during the year (which I haven’t actually been trying to do), it would go to a Roth — the perfect pseudo emergency fund. I don’t think you have to wait at all (?) to take out your contributions, only earnings you must wait 5 years for — right?

  7. So you can withdraw your contributions from a Roth without penalty–are you allowed to later return your withdrawals to the Roth?

  8. JJ states a common misunderstanding, one may always withdraw contributions from a Roth at any time without tax or penalty. It is earnings that must stay in the account for at least 5 yrs, otherwise their may be tax and penalty.

    Of course if one has their Roth in CD’s there is the financial institution’s early withdrawal penalty

  9. Totally awesome blog! After-tax cash is king in my book if you can afford it now.

  10. Shane Olaleye says

    My emergency fund is my Roth IRA. I thought a lot more people thought that way. When I hit the Roth limit, I start adding more to a GMAC MMA, but most of the money in GMAC has a destination anyway and it’s sitting there till the time arrives.

  11. SoontobeKSgrad says

    Let me see if I have this correct. It is ok by the tax books, if I open an Roth IRA but invest the money in a MMA then I can withdrawal the original principle I put in there but not the money i earned on interest as long as I don’t pull out more than $4k in one year? Then i can change the investment vehicle on the earned interest into more risky investments such as stocks and or mutual funds. If this is correct, I need to transfer my savings into an IRA as it would be a win win situation.

  12. great post, and couldn’t agree more. You really want to maximize the annual allowance you put into your Roth.

  13. Does anyone know the number of the form that you need to keep for documentation purposes for taking money out of a ROTH IRA?

    I have contributions dating back to when ROTH’s were first implemented and will likely take out some of this money when I buy a house. I have no idea what is needed for tax purposes on how to take money out of a Roth without paying penalty. Can anyone advise on the proedure?

    To stem off questions on withdrawing from IRA to fund home purchase, I have intended to do this. My net worth is 70% in IRA, and 30% in after tax, but since I have access to the roth contibutions, this makes the most financial sense for me right now.

    Thanks for any help!

  14. Great blog and post.
    Recently faced this decision and contributed $4k to my Roth. We’ll soon open a Roth for my wife and put $4k there too. Chose to invest conservatively, so we consider Roth part of our emergency fund, knowing we can withdraw amount equal to or less than our contributions if needed. Wish we invested in Roth earlier instead of traditional IRA. Trying to convince my employer to offer Roth 401k option, but they are very hesitant (25,000+ employees). Even though I believe the qualified distribution rules are different (we wouldn’t treat Roth 401k as emerg fund), I prefer Roth 401k over traditional. Any readers here have Roth 401k?

  15. My question is little bit off topic but still related to Roth IRA and your previous posts about retirement. I thought one can contribute to both SEP IRA and also Roth IRA. Infact I did that for 2006. I am reading conflicting information on the web. And the information on website isn’t that clear either. In your case, do you contribute to both SEP IRA and Roth IRA in one year? I remember you mentioned about using Solo 401K with Fidelity. Are rules different for Solo 401K and Roth IRA contribution for the same year?

  16. SoontobeKSgrad – I believe you can withdraw any amount of your contributions, anytime. That money has already been taxed at the income level. The $4k annual limit is for contributions, not withdrawals. For example, ff you had put in $3k/yr for 5 years I think it is perfectly fine to take all 15k out at once.

  17. Steve is correct – you can withdraw any amount of your contributions penalty free at any time.

    One additional thing to look at is the Retirement Savings Contributions Credit. For people of lower income (individuals up to $26000, married up to $52000 for 2007) the government will give you a tax credit for contributing to retirement accounts, in addition to whatever deductions are already in place. See form 8880 for more details, but just a couple of examples:
    – Single making $16K per year. If you contribute $4K to your Roth IRA, you get an $800 tax credit.
    – Married making $30K per year. Between you and your spouse you contribute $6K to your Roth IRAs, you get a $3000 (!!!!) tax credit.

  18. One correction for my previous post – the max tax credit is $1000 for singles and $2000 for married couples (I had forgotten about that).

    So, the my last example, a couple making $30K could contribute $4K to their Roth IRA, and get the maximum tax credit of $2000.

  19. Jonathon,

    Why did it take you this long to come to the same conclusion as commenter JBO? This logic is perfect. What were you thinking before?

  20. James has a good point the other thing to remember is that you can use a regular IRA to lower one’s AGI, I had one tax client who had already contributed to a 401(k) and was just over the threshold where the savers credit was 20% but by puting $150 in her Traditional IRA it lowered her AGI to where she qualified for a 50% credit so her credit went from $400 (20% of $2000) to $1,000 (50% of $2000)

    Dale asked about forms for showing the basis of the Roth IRA; each year the trustee of the ROTH must send a form to you and the IRS stating what you put in the ROTH ( I think it is a 5498 but don’t hold me to that), One needs to make sure that is issued each year one has contributions. One should keep those forms and a runing total of the basis (what one has put in) so in the rare instance the IRS would question it, one could prove the value of the basis. Then in the year one takes out the money one should file a 8606 part III (page 20 to show what if any was the taxable amount (it is a simple form or at least that part is)

  21. As usual, a great post. I think most people should have at least $1,000 in a savings account for emergencies. After that, everything should go into a Roth IRA as a backup emergency fund.

  22. why not contribute 3x’s monthly income to the emer-fund then cap it? everything else goes to retirement or other important goals such as home improvement, buff up a tangible asset. FYI, I hope you take the plunge soon…

  23. anyone know why in etrade you cannot transfer funds from a roth back to my bank account? Maybe they do not want to make it easy to withdraw and you need to call. I would like to do this suggestion but not sure if I can pull money out.

  24. I wouldn’t view this as an either/or – put $1K in cash, $3K in the Roth.

  25. I’ve never really considered my Roth as an emergency fund. But I started early enough in my saving that I wasn’t sure I could afford to put the money away. Knowing that the Roth contributions could be pulled out if things went south definitely gave me confidence to begin saving maximally, early.

    For years I’ve kept the bulk of my emergency fund in plain old EE savings bonds. Until the rule changes a few years ago, the return was reasonably good and I could defer taxes on the interest until they were cashed. If I were to buy savings bonds now, I’d use I bonds instead because the EE bonds aren’t attractive in my opinion these days.

    I discovered one disadvantage to using savings bonds for my emergency fund this year. I cashed some out to make a down payment on a land purchase and now I have unplanned taxable income to account for this year. I usually manage my precise amount of taxable income very carefully, so I effectively have to find pretax investments by the end of the year to offset that income (or use traditional IRA before April 15th).

    It seems to me somewhat inconvenient to have a higher tax bill precisely when you need to tap into your emergency fund. I’ve started to replenish my emergency fund, but I’ve been using money markets and T-bills instead. About half of my emergency fund is now savings bonds, and if I don’t need them I’ll use them when my daughter goes to college (and avoid the income tax).

  26. First find out the delay in withdrawing funds out of your Roth.
    If it is say, 1 month, then make sure your emergency cash fund is at least 1 month.
    Now fund your Roth as much as possible.
    In the event of an emergency you withdraw some contributions (and earnings where applicable) from the Roth.
    During the 1 month withdrawal delay you tap into your 1 month cash buffer.

    You end up maximizing your Roth while being prepared for emergencies.

  27. Financial Tips for WAHMs says

    Great post! I agree that Roth IRAs can be used for emergency funds – especially since they are so flexible and you can get your contributions out penalty free at any time – but I prefer to have a mini emergency fund first, then fund the Roth IRA.

    You can access the mini emergency fund very quickly (faster than a withdrawal from a Roth IRA), and this allows you to invest your Roth IRA for retirement instead of emergencies.

  28. According to my interpretation of this IRS guideline, there is a penalty if withdrawn within 5 years of contribution:

    However, this would disagree:

    Does anyone have a credible hardcore source?

  29. I would go with the Roth IRA. The fact that it is the most absolute use it or lose it investment makes this decision. The Roth IRA certainly could be taxed in the future, which plays into the decision quite a bit as well. Building wealth through the Roth is an amazing investment.

  30. Aaron: are you suspecting that current Roth contributions or future Roth contributions would be taxed?

  31. Wes,

    Would you rather or rather not contribute to an IRA?

    The second article tells the truth, but it speaks of an emergency account as if someone were actually planning for an emergency. Yes, if you have the money, you want to have an emergency fund separate from a Roth IRA and refrain from withdrawing from your IRA. But, Jonathan’s original post put us into a scenario where we’d only have enough money for one. In that case, it’s best to go with the Roth IRA.

    As for the IRS penalty if withdrawing within 5 years, that applies to earnings. Since you’ve already paid taxes on the principal they IRS can’t legally re-tax you. Such would be unconstitutional and wouldn’t hold up in court. It’s the double-jeopardy principle.

    The same principle applies in reverse if you have overseas income. If you have untaxed overseas income that you do not pay taxes to the U.S. on as “earnings”, you cannot contribute to a Roth. (Because you’ll never end up paying taxes) You can most likely contribute to a Traditional IRA, since the repatriated income will at some point face U.S. taxes upon its withdrawing.

    I’m not an accountant or a attorney (yet), so take any of this as bonafide legal advice, but if aren’t sure, it’s better just to ask your financial and legal counsel.

  32. I heard that you can take $10000 from your Roth IRA to purchase your first home.

    My wife and I are living in a home that I purchased before we got married, and the home is under my name.

    The question I have, can my wife take $10000 from her Roth IRA to purchase her first home?

  33. Greling: I don’t quality for a ROTH. I’m simply trying to ascertain the facts.

    You mention the IRS re-taxing. We are talking about a penalty, not a tax. They certainly can apply penalties, just as they do on a non-qualified IRA distribution: you pay the tax and a penalty.

    Don’t you mean “[don’t] take any of this as legal advice”? I would take neither legal nor financial advice from a blog or blog commenter.

  34. the big point re: RIRA is that you can never, ever replenish your RIRA for what you took out.

    The more important thing people should consider, though, is that you need to keep separate different monies for their different intended purposes. People should stop mixing investment monies with emergency fund monies with retirement monies. They all have different purposes and should therefore be treated differently.

    The intent for an emergency fund is not to fund retirement or maximize return or to pay for a new TV. You want to maintain a liquid/semi-liquid account that has no bearing on your retirement or other savings plans and goals, because you want it in case of an emergency or income disruption. Greling, this is exactly why people advise to have an emergency, is because there will invariably be one. So, yes, you should plan as if you are going to have one. Stuff happens.

    The intent for retirement savings is to maximize monies for retirement. If you deplete it, you lose a lot of your past investment and in the case of RIRA you cannot make it up. You do not want to need to withdraw from your retirement in order to pay for an emergency. If something catastrophic happens, then yes, you could tap into retirement savings, but with an emergency fund, you have a buffer.

    The fact is, if you cannot maximize both, then perhaps split $2k each into RIRA and towards an emergency fund. Your big financial picture needs to maintain money for separate purposes.

  35. Wes is correct, the regulations are quite clear. Look at the IRS RULES not some yo-yo?s interpretation of the rules. Using a ROTH IRA as an emergency fund is a terrible idea. Unqualified distributions before age 59 ? are assessed a 10% penalty. Some people might misinterpret this
    ?Withdrawals of contributions by due date. If you withdraw contributions (including any net earnings on the contributions) by the due date of your return for the year in which you made the contribution, the contributions are treated as if you never made them. If you have an extension of time to file your return, you can withdraw the contributions and earnings by the extended due date. The withdrawal of contributions is tax free, but you must include the earnings on the contributions in income for the year in which you made the contributions.? from
    Penalty free withdrawals are only available in the year you make them BEFORE you file your tax return. There are some other exceptions, but they are sufficiently narrow to neuter the ROTH as an emergency fund.
    If you feel that the IRS cannot double tax you, then you can elect to not pay the penalty and run the risk of ending up like these folks.

  36. Corrected link from above comment.

    If you feel that the IRS cannot double tax you, then you can elect to not pay the penalty and run the risk of ending up like these folks.,1,1392703.story.

  37. Any suggestions as to the best company to open up a Roth IRA with? Not knowing too much about it, I opened one with ING Direct several years ago, and things seem to be going smoothly, but I wonder if there is something better out there. We’d like to open one up for my husband this year. Any suggestions?

  38. Regarding the withdrawal of Roth IRA contributions – I haven’t waded through the IRS docs recently, but I will try to later.

    I consider Fairmark to be credible (their books are published in print form and are used as references, not just some internet scrawling). See their page here: tax-free Roth IRA distributions.

    “The rules for Roth IRAs permit you to do something that isn’t allowed for regular IRAs: withdraw the nontaxable part of your money first. Distributions from regular IRAs come partly from earnings and partly from contributions. But when you take money out of a Roth IRA, the first dollars you take out are considered to be a return of your non-rollover contributions. You don’t have to meet any special tests to receive those dollars free of tax. You can take them out any time, for any reason, without paying tax or penalties.”

    Camilla – My personal preference is Vanguard. It’s the company I told my mom to roll her IRA over from American Century, and it’s where my IRAs are, so I put my money where my mouth is 🙂

    Some people like brokerages if they trade individual stocks or ETFs instead of mutual funds.

  39. Jonathan,

    I waded through the docs and I stand corrected. The interesting bits were hidden in the opening paragraph.

    From Publication 590

    Are Distributions Taxable?

    You do not include in your gross income qualified distributions or distributions that are a return of your regular contributions from your Roth IRA(s). You also do not include distributions from your Roth IRA that you roll over tax free into another Roth IRA. You may have to include part of other distributions in your income. See Ordering Rules for Distributions, later.
    Basis of distributed property. The basis of property distributed from a Roth IRA is its fair market value (FMV) on the date of distribution, whether or not the distribution is a qualified distribution.

  40. Mark – I did as well, I am currently writing up a post on this very stuff. Quickly:

    1) They are not qualified distributions (Figure 2-1 of Pub 590)

    2) However, even they are non qualified, they are not taxable (Worksheet 2-3 of Pub 590)

  41. I fully agree with your stance on ROTH vs emergency fund contributions. The ability to take out those after tax dollars at any time allows you free access to your funds at any time while also allowing you to take advantage of higher rates of return via investing.

    Great post!

  42. I want to know if I should convert my IRA into a Roth IRA, given that I want to try to buy a home within the next three years. My understanding is that the Roth IRA will not permit me to take money out to put a down payment on a house until the account has been open for 5 years (without incurring taxes). Experts say that a Roth IRA is better than a traditional IRA. But I don’t want to wait 5 years before buying my first home, so wouldn’t it make more sense to just keep my money in a traditional IRA until I’ve bought a home? (FYI, I live in the San Francisco Bay Area, where housing prices are very far above national averages. I am 38 years old, single, and make about $85,000 a year.)

  43. Carolyn,

    If you convert your IRA to a ROTH you will need to pay the tax on the amount you convert. Remember however that it will be added to your Adjusted Gross Income (AGI). You do not have to wait 5 years to take money out of the ROTH, as long as you don’t take out the earnings. You may always take out your contributions without tax or penalty!! You may take $10,000 out of your IRA without penalty (but you will still pay the tax) for the purchase of a first home.

    So you are in the 25% bracket and getting close to the 28% bracket, you are in California so your state tax rate is not small either. You said you were single so I am assuming no kids, if you have kids you are in the Head of Household status and this would not apply. I would be VERY careful about moving money from your IRA to a ROTH you are going to lose 25% plus your state rate on every dollar you move. The best option for you might be to fund your ROTH now then in three years take out what contributions are needed to buy your house. If you needed a little more you could then take out up to $10,000 from your IRA. You didn’t say if you had a 401(k) or not. If you do you should be funding it as well, if not you should be funding your IRA. The IRA and 401(k) contributions are going to reduce your AGI and that is the best way to pay less income tax. Taking money out of your IRA, either by conversion or and early withdrawal adds that amount to your AGI and therefor to your taxable income it sometimes pops you into the next tax bracket.

    Now that doesn’t mean that if you have $1,000 in a IRA that isn’t making much (say at a bank) you won’t be better to convert it. But you don’t want to go taking $50,000 or $100,000 and converting it, in CA you’d lose about 40% of it to tax. You have to have a great return on investment make that up.

    Clear as mud? Consult a tax advisor BEFORE you do any converting. Now is the best time, before the tax year ends.

  44. Thank you, Rick, for your very detailed and excellent advice on converting my IRA to a Roth IRA! I really appreciate it!

  45. hi,
    I was trying to come up with similar calculations of emergency fund( taxed account ) vs. traditional IRA for those that are unable to invest in Roth.
    Also this traditional IRA could be money thats invested after tax since there might be a few people out there who have company sponsored 401k and still want to invest more into an IRA.

    Any feedback?

  46. What’s the difference between Roth IRA withdrawals and distributions? I thought distributions are only allowed in the following scenarios:
    (btw, your Roth IRA must also be atleast 5 years old before you can take any money out of it without getting hit with taxes/penalties?)

    Any ‘qualified distributions’ you take from a Roth IRA will NOT be included in your taxable income, hence making you exempt from paying taxes. You won’t have to pay taxes on the original principal you contributed nor any taxes on capital gains & earnings you have accumulated. Pretty sweet you think for Roth IRAs, eh? In order for the distribution to be classified as ‘qualified’, it must be taken under 1 of the following circumstances:

    – the Roth IRA investor must be 59 and 1/2 years or older at the time of the distribution
    – the Roth IRA investor becomes disabled at the time of taking the distributions
    – the Roth IRA investor dies and his/her beneficiary receives the assets contained in the plan
    – the distributions taken from the Roth IRA will be used in the purchase or building of a new home for the Roth IRA holder or

    qualified family member. This is limited to $10,000 per person per lifetime. Qualified family members include:
    –> the Roth IRA investor
    –> the Roth IRA investor’s spouse
    –> children of the Roth IRA investor
    –> grandchildren of the Roth IRA investor
    –> parent or ancestor of the Roth IRA investor

    Source: (removed)

    Note: Even if one of the above prerequisites is met, the Roth IRA must be atleast 5 years old before any distributions can be taken. This is a very important point to consider. For example if you set up your Roth IRA in March 22nd, 2003, you cannot take any distributions, even if they are qualified, until March 22nd, 2008. If you do, this distribution will not be qualified and you will have to pay the 10% early withdrawal penalty as well as income taxes.

  47. “Andrew” – If you run a website about Roth IRAs, it would be a good idea to know that you can withdraw contributions at any time without penalty. 😉

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