Roth IRA as Emergency Fund?

This article was originally published on July 23, 2003.

My wife and I are crazy. We're thinking of having another kid, maybe two more.

While having kids is challenging enough, we have special circumstances. During our first pregnancy, Elizabeth -- because of a risk of preterm labor -- was put on "bed rest" for two months. She was allowed to go to the bathroom and take a shower, that was it. We sometimes cheated by driving a mile to the nearest Starbucks (Nasdaq: SBUX  ) , but my wife was otherwise homebound. For our second pregnancy, Elizabeth was in bed for four months. At this rate, if we have another kid, Elizabeth will be bedridden by the morning after.

If we want to have Baby Bro #3, we have to plan ahead. We have to be prepared for her lost income and our increased expenses, including medical bills and child care. So we've set aside $12,000 in our "propagate the species" fund.

Conventional wisdom says we should keep this money somewhere safe and liquid, such as a money market account. After all, this is like an emergency fund, and we shouldn't take risks with such things.

Except that we may not need all that money. What if we decide not to have any more children? Or what if we decide to enlarge our family some other way, through adoption or Overstock (Nasdaq: OSTK  ) ? Or what if we don't end up needing the whole 12 grand? That money will have been twiddling its thumbs for years, earning paltry interest in a bank account.

One possible solution: Deposit some of the money in a Roth Individual Retirement Arrangement.

"What?!" you're thinking. "Use a Roth IRA for an emergency fund?! Call the child protective services people -- this man is unfit for parenting and should be sterilized!"

Kids today
It's not as crazy as it sounds (using a Roth as an emergency fund, that is -- not my sterilization). Unlike the money in a traditional IRA or an employer-sponsored retirement account -- which is taxed and penalized if withdrawn before the account owner turns 59 1/2 in most cases -- contributions to a Roth IRA can be withdrawn anytime and for any reason, penalty- and tax-free. However, the earnings will be taxed and penalized if withdrawn before that magic age (with some exceptions).

"But money in an IRA is for retirement only," you're saying. "And I'm still calling the child protective services people because your son swallowed a penny last weekend!"

Yes, it's true. During a joint sorting/financial educational moment, my son swallowed a penny. As many of you fellow irresponsible parents know, such an event is followed by days of looking for the penny in the child's... well, you know. The penny was recovered, and you should have seen the look on Abe Lincoln's face. Thus, your children are not a good place for your emergency fund, because the money is not easily or pleasantly accessible.

It is also true that money in an IRA is generally meant for retirement. My wife and I contribute to other retirement accounts, so we'll be fine if we end up needing the entire $12,000 during the next pregnancy. But if we don't, the money we put in a Roth will be a nice addition to our nest egg.

"Well, why not keep the emergency money aside and contribute to a Roth IRA?" you're thinking.

Because we can't do everything. Financial planning is the fine art of apportioning limited resources among various goals. Should you pay off the mortgage or acquire a rental property? Pay off the credit card or build an emergency fund? Save for college or save for retirement? It's a fine, and imperfect, balancing act.

Regarding that final question, some people use the Roth IRA to save for both. Money in a Roth can be used for higher-education expenses. The contributions can, as previously mentioned, be withdrawn without consequence. The earnings can be withdrawn penalty-free as long as the account has been open for five years, but you'll still have to pay taxes. So if Junior needs the money, it's there. But if he doesn't -- because he doesn't go to college or because he got a scholarship -- your retirement looks that much better.

The pitfalls
There are many pitfalls to thinking of a Roth IRA as a source of funds for something other than retirement. First of all, most people use their IRAs for long-term assets such as stocks. However, if you use the money for short-term purposes, you either (1) have to be more conservative and therefore sacrifice potential growth, or (2) risk selling assets at inopportune times, such as when they're down 25%.

Secondly, and perhaps most importantly, thinking of your Roth as a potential source of preretirement funds creates a dangerous mind-set. It's a slippery slope from genuine emergency (disability) or stated goal (college) to excuses for compromising your retirement (vacation, new car, or nose job). This strategy should be employed only with money that has a good chance of not being used until you kiss or spank your boss goodbye.

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Since the first publication of this article, Robert Brokamp, the editor ofRule Your Retirement, and his wife have begun the process of adopting a child, which is just as expensive as being on bed rest but allows for more trips to Starbucks.


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