Can Your Roth IRA Be A Back-Up Emergency Fund?

A Roth IRA, or Individual Retirement Account, is an investment account. But here, I’d like to instead discuss the possibility of using a Roth IRA as a back-up emergency fund. As well as debate whether you should use it as one.

Roth IRA emergency — *Smirking like he’s figured out a loophole…but has he?*

What is a Roth IRA?

Let’s start basic because up until a few years ago, I had no idea what a Roth IRA was.

First, an IRA, or Individual Retirement Account, is a tax advantaged investment retirement account that anyone earning money through gainful employment can open. Basically, if you make any kid of income, you can open an IRA. And you can contribute up to $6,500 (in 2023) annually to this account.

However, IRAs come in two flavors…traditional and Roth. Not as delicious as chocolate and vanilla. But functional…

A traditional IRA works much like a 401k or 403b in that the money you contribute is pre-tax. However, the money gets taxed when it is withdrawn in retirement.

On the flip side, a Roth IRA (Roth is the name of the senator who sponsored the bill) works differently. When you contribute to a Roth IRA, the money you contribute gets taxed up front. However, it is never taxed again. Not even when you withdraw it years later in retirement.

Can doctors even contribute to a Roth IRA?

This is an important question because one of the biggest hang-ups with IRAs is that there is an income limit above which you do not get to use these tax advantages.

The income limits change each year and depending on tax filing status. But suffice it to say that all physicians will be above these limits. This doesn’t mean you can’t contribute to an IRA, it just means that you won’t get any tax benefits when you do. So what’s the point. Investing in a taxable account is way better as that money does not have age limits or penalties for withdrawal like IRAs do.

However, there is a caveat…

And that caveat is the colloquially named Backdoor Roth IRA. This is a totally legal thing in the tax code that allows higher income earners to still benefit from a Roth IRA.

If you are above the income limits, what you do is simply contribute money to a traditional IRA. Since you are above income limits, you will contribute post-tax (instead of pre-tax money). Then, you convert that traditional IRA into a Roth IRA. This conversion carries no tax consequences as long as the money you contributed into the traditional IRA did not grow from investments (typically this conversion should be done a day after you contribute initially) and you did not violate the pro rata rule by having investments in another traditional or SEP IRA.

And then, you are the proud owner of a Roth IRA. You can invest this money and you will never pay taxes on it again.

This is a huge advantage and why a backdoor Roth IRA should be high on your investment waterfall as described here.

That’s great but what does this have to do with emergency funds?

Emergency funds come into play for a few reasons. Put simply, most people don’t like the idea of emergency funds. They seem boring. It’s a big chunk of money just sitting there not doing much. So, we get anxious to invest it or put it to work.

Which in general is a good thought and strategy.

The problem is that it just defeats the purpose of an emergency fund. Because remember, an emergency fund is 3-6 months of your living expenses saved in a liquid place that you can withdraw from for (guess what) an emergency. And an emergency is by definition unpredictable.

So, investing your emergency fund doesn’t make sense. Because if you invest it in the stock market and then need it on a day we go into a bear market, you might not have enough money to cover your emergency anymore!

But again, people try to get creative and the idea has come up that you can use your Roth IRA as a sort of back-up emergency fund. And therefore keep less money in their boring, typical emergency fund, freeing up more money to invest elsewhere.

Before getting into if this is a good idea or not, let’s examine where and why this idea developed…

The origin of the Roth IRA emergency fund concept

A Roth IRA is a retirement account. However, it does have unique advantages that separate it from other “pre-tax” or “tax deductible” retirement accounts like a 401k, 403b, or traditional IRA. And these advantages position it as a potential back-up for an emergency fund.

Principal can be withdrawn penalty-free

For tax deductible investment accounts, you cannot withdraw from them before you reach a certain age. These ages differ based on account type but are generally in the 60-65 year old range.

If you do withdraw before this age, you get hit with a steep 10% penalty. That makes withdrawing from these accounts early prohibitively self-sabotaging.

However, with a Roth IRA, you can withdraw from your principal anytime without penalty. So, if you contributed $20,000 over the years and the money grew to $30,000, you could still withdraw up to $20,000 (your principal) without penalty.

This is the main reason people see the Roth IRA as a back-up emergency fund. Because in a pinch, they can withdraw principal to pay for an emergency. But there are a couple other reasons too…

There are no RMDs

With a traditional IRA, there are something called Required Minimum Distributions or RMDs.

RMDs basically mean that when you hit a certain age (70.5 years old), you need to withdraw a certain proportion of your account investments. The reason for this rule is that these accounts are pre-tax. So the government forces you to withdraw money and pay taxes at some point.

But since a Roth IRA is post-tax, you’ve already paid the government their taxes. And they no longer care when you withdraw the money.

This is an advantage because if you have to withdraw some principal from your Roth IRA for an emergency, you could let it keep growing further into the future without needing to withdraw and reduce it’s compound interest potential at a certain age. This is mostly an advantage for those planning to leave their Roth IRA as a legacy to heirs. It doesn’t really help you if you want the money to actually spend in retirement.

And lastly…

There are no tax implications

When you withdraw from a Roth IRA, there are no tax implications. You already paid your taxes.

So, if you need to withdraw principal for an emergency, it’s not like you also need to worry about footing a larger than expected tax bill that year.

You can see why a Roth IRA is an attractive option as a back-up emergency fund. There are certain characteristics that lend themselves well. However, now that we know we *could* use our Roth IRA as such, we need to discuss if we *should* do it.

Should we use our Roth IRA as a back-up emergency fund?

I don’t recommend it. For a few reasons.

First, as a doctor, you earn enough money to create a boring emergency fund that can sit in a savings account like it should AND invest in a backdoor Roth IRA. If you don’t think you can, I encourage you to take a look at your spending and consider budgeting using my simple template. Because you likely have a sending problem.

Second, your Roth IRA is an investment account. Everything has a purpose. And that is its purpose. So use it like one. It’s a bit akin to people who fully fund an HSA and then withdraw the money a few years later to actually pay for health expenses. The idea is the use the HSA as a stealth investment account. So don’t dip into the honey pot. Same idea here.

Third, by withdrawing any significant amount of principal, you severely restrain and reduce your ability to use compound interest to exponentially grow your investments in that account. It’s generally just not worth it.

Fourth, there is always still the potential that you need the money for an emergency when the stock market is down. And this can reduce your principal available to withdraw penalty free. Then you are really in a pickle.

And last, if you want to use your Roth as an emergency back-up to free up more money to invest elsewhere, there is a decent chance you will not actually invest that extra “freed up” money. But you will instead spend it…likely unintentionally. It’s just human behavior. There is no judgement. I succumb to it as much as the next person.

So how should you create and maintain your emergency fund?

Build a savings rate of at least 20% of your gross income and allocate much of that to according 3-6 months of expenses as an emergency fund
Keep that emergency fund in a high yield savings account or money market fund where it is very safe and liquid
If you really want a back-up emergency fund, consider a HELOC although this should only be a supplement to your regular emergency fund, not in place or all or a portion of it
Create stable, monthly passive income through real estate investing or medical side gigs like consulting to supplement your ability to cover emergencies

What do you think? Can a Roth IRA be a back-up emergency fund? Should it? Why or why not? Let me know in the comments below!