If there's one thing the coronavirus pandemic has taught us, it's that it's important to have extra money on hand at all times. That way, if you lose your job or encounter an unplanned expense your paycheck can't handle, you can dip into your cash reserves and avoid going into debt. You can also avoid a scenario where you feel compelled to liquidate investments and lose out on added growth, or worse yet, lock in a permanent loss when the need for money arises.
As a general rule, it's a good idea to keep about three to six months' worth of living expenses tucked away for emergencies. And you'll often hear that you should keep that money in a savings account.
But that poses a problem. Given what savings accounts are paying today in interest, leaving that much cash in one could mean denying yourself much more generous returns. And if that doesn't sit well with you, you may be considering finding another home for your emergency fund, like a Roth IRA.
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But is that a smart move? Or should you limit yourself to a savings account only?
How Roth IRAs work
A Roth IRA is a retirement savings plan, and contributions are made with after-tax dollars. Investment gains and withdrawals, however, are yours to enjoy in retirement tax-free.
You'll often hear that a Roth IRA makes sense if you expect your tax rate in retirement to be higher than what it is today. Also, Roth IRAs are the only tax-advantaged savings plan to not impose required minimum distributions during retirement.
Can a Roth IRA be a good place for emergency savings?
When you fund a traditional tax-advantaged retirement plan (one that gives you a tax break on your actual contributions), you're penalized if you remove money from it before reaching age 59 1/2. But Roth IRAs work differently. Because Roth IRAs are funded with after-tax dollars, you're allowed to withdraw your principal contributions at any time without penalty (though if you touch your gains, a penalty could apply).
Here's what that means. Say that over a 10-year period, you put $50,000 into a Roth IRA but your investments grow your balance to $60,000. You can remove your original $50,000 at any time and avoid being penalized, but if you touch the $10,000 in gains portion of your account, you could be dinged.
There's the potential to earn much better returns in a Roth IRA than you'll get in a savings account, especially given where today's interest rates are sitting. And since there's no penalty for removing your principal contributions early, you may want to consider housing your emergency fund in a Roth IRA.
But if you're going to go that route, make sure to follow one key rule -- have another retirement savings plan earmarked solely for your senior years. Saving for retirement is essential because Social Security generally won't pay you a high-enough benefit to live comfortably. If you raid your retirement plan ahead of retirement, you'll risk falling short when your senior years arrive, so you'll need some savings that you pledge not to touch, even when emergencies strike.
Another thing to keep in mind is that if you house your emergency fund in a Roth IRA, it could lose value if your investments decline. Therefore, a safer bet for guarding your principal is to keep that money in savings. But if you really can't bear the thought of losing out on growth, then you can move forward with a Roth IRA, as long as you understand the risks involved.
It's always important to be prepared for a financial emergency, and a Roth IRA could be a reasonable place to stash your savings. But don't combine your emergency and retirement savings -- that's just not a wise move. Rather, make sure you're saving adequately for each purpose.
