The basic building blocks for successful personal finances are creating an adequate emergency fund and consistently saving for retirement. In this week’s article, we look at a rule that allows investing in a Roth IRA account and use it as a part of your emergency funds if needed. As a refresher, you can learn more about the value of emergency funds here.
The Goal
Emergency Reserves. One of the most prominent mistakes families and individuals make is not having an adequate emergency fund. Everyone needs one, and we typically recommend three months of household expenses as the minimum target amount. So, if it takes $5,000 per month to pay your regular bills, ideally, your emergency reserve fund should be a minimum of $15,000.
Retirement Investing. It is also important that workers save for their retirement in their employer’s 401k, an IRA, or Roth IRA. Your annual target contribution here is a minimum of 10% of your gross income. So, if you make $60,000 per year, you should be investing a minimum of $6,000 per year into a retirement account (including any employer matching contribution). As your income rises, so should your contribution amount.
The Problem
Most people find themselves without enough money at the end of the month to do both – save for an emergency reserve account and save for retirement.
The Solution
One strategy is to use a little-known rule allowing you to invest in a Roth IRA and use it as part of your emergency reserve account. With a Roth IRA, contributions are not tax-deductible, but money invested grows tax-deferred, and withdrawals at retirement are tax-free.
What is little-known is that you can withdraw your ‘contributions’ from a Roth IRA at any time without suffering a penalty. Withdrawals of the earnings portion of your Roth IRA are subject to income taxes and a 10% federal penalty under certain circumstances.
Let us assume you have, over the years, contributed $15,000 to a Roth, which is now worth $21,000 due to investment returns. If you had an emergency, you could withdraw up to $15,000, at any time, without a penalty. Obviously, pre-retirement withdrawals from your Roth IRA are not ideal. They should be a last resort because those funds cannot be put back, and you lose the future tax-free growth, but this could be a good solution for a portion of your emergency reserves, especially if it encourages you to save more for retirement.
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