Anyone who's just starting to get their finances in order faces a lot of competing priorities. They're told they need to pay down debt or build an emergency fund, all while saving for retirement too. But when your budget is already stretched, finding money to put into all of those buckets can seem impossible.
Luckily, there's one clever way you can make some of your money pull double duty -- helping you save for retirement and build an emergency fund at the same time. The key is using a Roth IRA.
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Why the Roth IRA is different
The Roth IRA has one important feature that separates it from just about every other tax-advantaged retirement savings account: You can withdraw your contributions tax-free and penalty-free at any time, for any reason.
That means if you contributed $3,000 to a Roth IRA for 2023 (which you can still do until April 15, by the way -- taxpayers can contribute to an IRA for any given year until Tax Day the following year), you could withdraw up to $3,000 from your Roth IRA at any point. However, any investment returns you've accrued in the account must remain in it. You can't take your profits out early without being hit with penalties.
Even the Roth version of a 401(k) isn't as flexible when it comes to early withdrawals. While you can withdraw your contributions penalty-free from a Roth 401(k), any withdrawals are split between contributions and investment returns on a prorated basis. That typically results in at least a small penalty for early withdrawals from a Roth 401(k). The Roth IRA, on the other hand, counts any withdrawal as a contribution-first withdrawal, so you can avoid penalties entirely.
Who should use a Roth IRA as an emergency fund
All that said, most people should not use their Roth IRA as an emergency fund. There are often better places to keep your emergency savings. This strategy is only useful for those who are struggling to both save for retirement and build an emergency fund. Those people would likely leave the opportunity to fund a Roth IRA on the table. And if you don't take advantage of your Roth IRA contribution in a given year, there's no opportunity to make up for it later.
Using a Roth IRA as an emergency fund allows you to get money into a tax-advantaged retirement investment account and start investing it as soon as possible. That can jump-start the process of building your retirement nest egg but still ensure you have access to some cash if you really need it.
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Keeping your emergency fund in a Roth IRA also presents another advantage. It's slightly harder to access than a simple savings account. While that might seem like a disadvantage, the fact there are a few extra hurdles involved in taking a Roth IRA withdrawal could help you avoid giving in to the temptation to use some of your emergency savings for non-emergencies.
Ultimately, the hope is you'll never need to tap your Roth IRA for a financial emergency. And eventually, you should build an emergency fund in a more traditional bank account while continuing to add to your retirement investments.
Where to invest your Roth IRA emergency fund
When you're using a Roth IRA to house your emergency funds, you shouldn't be investing them quite like one would for a typical retirement portfolio. In this case, capital preservation is the name of the game, so you should be putting those funds into safe financial instruments like money market funds or certificates of deposit.
A money market fund is a top choice. These funds are highly liquid and provide returns similar to what you'd get from a money market account at a bank. You simply buy the fund in your Roth IRA brokerage account like any other mutual fund, so make sure the Roth IRA provider you choose supports mutual funds.
A certificate of deposit (CD) is less ideal because most of them lock your investment in for a certain length of time. In exchange for those fixed holding periods, CDs tend to offer rates higher than what savings accounts pay, or at least, they allow you to lock in a guaranteed rate for longer. To access the funds you have in CDs early, you may have to pay penalties equivalent to several months' worth of interest, although some banks do offer no-penalty CDs with lower rates. As a result, if you're going to use CDs to hold your emergency savings in a Roth IRA, it's best to use short-term CDs. And if you want to use CDs, you'll need to make sure your IRA provider supports them.
Again, the hope is you'll never have to withdraw money from your Roth IRA to cover an emergency expense. But if you do, these investment options will make sure you have access to that cash when you need it. Any amount your contributions earn should stay in the account, and you can invest those funds in more aggressive growth assets like stocks. That way, you can use your emergency fund savings to help jump-start your retirement savings, even if your budget is tight.
