3 Reasons to Use a Roth IRA for Your Emergency Fund

If you're struggling to both set up an emergency fund and save for retirement, you may be experiencing some money frustrations. You probably know that both tasks are important, and that you should get started on them as soon as you're able to, but when your resources are limited, you may feel as if you have to pick one or the other.

If you only have room in your budget to save for an emergency fund and can't contribute to your retirement savings right now, you should consider putting those funds in a Roth IRA account. 

Before I explain why this can be a good strategy, let me clarify: If you have enough income that you can properly save for an emergency and fully fund your retirement accounts, then this advice isn't for you.

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Roth IRAs have a unique characteristic

A Roth IRA is a tax-advantaged retirement account, but unlike a traditional IRA or 401(k), you do pay taxes on your contributions to it. The advantage is that you'll be able to withdraw your funds tax-free in retirement. As a bonus, you can withdraw your contributions to a Roth IRA -- but not your earnings -- at any time, without penalty.

Because it gives you the option to withdraw funds as needed -- for example, if you have an emergency -- a Roth IRA can be a useful tool for saving for all sorts of goals, not just retirement. Here are three reasons to house your emergency fund in a Roth IRA if you otherwise wouldn't be maxing out your retirement account contributions.

1. Contribution limits: use it or lose it

You're allowed to contribute a certain amount to your IRA every year. For 2020, that limit is $6,000 if you're under 50, and $7,000 if you're 50 or older. But if you don't make your contributions before the annual deadline (the date that federal taxes are due for that year), the ability to use that year's cap disappears forever.

Over time, you want to maximize the amount of money in your tax-advantaged retirement accounts. By putting your emergency savings into a Roth IRA, you can do that.

It's possible you won't have to tap your emergency fund for several years. And if your financial picture improves in that time, you may be able to both max out your retirement accounts and build a proper emergency fund in a regular savings account. In effect, you'll have managed to save more for retirement than you otherwise would've been able to.

If you do have to use your emergency fund, you'll be no worse off than if you left it in a traditional savings account. There's no downside.

2. Earn better returns than a savings account

People typically leave their emergency fund in a savings account. But even the best savings accounts are only offering interest rates of 0.8% right now. It's possible to earn much better returns within an IRA since you have lots of investment options.

That said, I wouldn't recommend investing your emergency savings in risky assets -- especially if you're struggling to save already. Capital preservation is the name of the game. You could buy something simple that's only meant to keep up with inflation like a TIPS mutual fund. You could build a ladder of CDs too.

As you contribute more to your Roth IRA over the years, you can move a greater percentage of your holdings in the account to stocks. While stocks come with volatility -- and the possibility that your investments may have declined in value at the time you need to sell some of them so you can access those emergency funds -- over the long term, the growth potential you gain by being invested in stocks should outweigh the risks. And the more money you have in the account, and the more diversified your holding in it, the better you'll be able to absorb the volatility.

It's important to remember, though, you can only withdraw your contributions without penalty or taxes. If you withdraw any of the earnings before age 59½, you'll have to pay a penalty as well as taxes on the earnings.

3. Get a boost from the IRS

If you're struggling to save for both an emergency and retirement, your income might qualify you for the Saver's Credit -- a tax credit you can receive for contributing to a retirement account. In order to get the credit, however, your adjusted gross income needs to be below a certain threshold.

Up to $2,000 of contributions per person can count toward the credit, and the actual credit is calculated based on the following table in 2020.

Data source: IRS. Income = Adjusted gross income.

So, if you're single and have an income of just $30,000 this year, but you're able to put aside $2,000 in your Roth IRA, the IRS will give you an extra tax credit of $200. Married couples with an AGI below $39,000 can reduce their tax bill to $0 with the Saver's Credit if they each contribute to an IRA.

It's important to know that any withdrawals you make from your Roth IRA will count against your contributions for calculating this credit for three years.

Capitalizing on the Saver's Credit can earn you a better rate of return than any savings account or even any investment option in your Roth IRA. It's just another reason to use a Roth IRA to hold your emergency fund.