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The Roth IRA Tool Chest Series: The Roth "Emergency Bin"

The Roth IRA is most often viewed as a retirement tool. That makes sense, since “IRA” stands for Individual Retirement Account. Just because it is called a retirement account, however, doesn’t mean it can’t be used in other ways. In fact, there are features built into the Roth IRA that make it perfect for many other uses. This article is the first of a series that will discuss many efficient, creative and often overlooked ideas related to the Roth IRA.

The first Roth IRA tool we will discuss is something I call the “emergency fund storage bin.” For many people, especially younger adults, limited resources make it challenging to balance saving for both emergencies and retirement.  With a Roth IRA, you can do both at once.

Here is an example: A young adult (we will call her Amelia) just out of college starts her career in the medical profession. At the one-year mark of her employment, and after taxes, expenses, and funding her 401(k) up to the employer match offered by her company, her remaining income from that year still allows her to save an extra $4,000 for an emergency. It is prudent for everyone to have at least 3-12 months of living expenses saved for an emergency, and for retirees possibly even more. Amelia is a nurse with good job security and after analyzing her situation with her financial advisor, it is determined that the equivalent of 6 months of expenses in her emergency savings is appropriate.

Most advisors would suggest adding those funds to a readily-accessable savings account. I would recommend that Amelia keep some funds in a savings account for small emergencies, and add the remainder of her savings to a Roth IRA. Presume Amelia already has one month worth of expenses in her bank savings account. She can add this year’s additional savings ($4,000) to a Roth IRA, investing those assets into a very conservative no-load, low cost ultra-short term bond fund. Roth IRAs have a unique feature that Amelia could then take advantage of - the ability to withdraw the principal at any time, tax and penalty free. This makes the Roth IRA an excellent depository for emergency funds in her case. At most custodians, it is also possible to establish a link between bank accounts and a Roth IRA account so transfers between them can be completed within days.

What’s another benefit of investing Amelia’s extra emergency savings into a Roth IRA when her income is limited? Well, emergency funds are not always used and moving savings into a Roth IRA potentially for a long term can be extremely valuable. By starting this practice early, she is potentially able to take advantage of years of compound returns on her investments. Note that Roth IRAs do limit how much can be deposited each year ($5,500 for those under 50 years old) and once higher income levels are reached, savers cannot add to a Roth IRA at all (phase out for a single person is $117,000-$132,000 for 2016).

Let’s fast forward three years. Amelia is doing well in her career, got a promotion and her income is higher (but she is still under the Roth IRA income limits). She has been adding $4,000 per year to her Roth IRA and had no emergencies. She now has over $12,000 in her Roth IRA and finds that she can afford to save an extra $15,000 per year.

Now the plan changes a little. Amelia can maximize her Roth IRA contribution ($5,500) each year and add to her bank savings account until such time as it covers 6 months of living expenses. At that point, she could begin to invest the funds in her Roth IRA a little more aggressively to seek higher (and tax free) returns.  Ameila would then make retirement the primary goal for her Roth IRA since the bank savings account now covers her emergency needs.

By adding money to her Roth IRA instead of ordinary savings during the early years of building an emergency savings, Amelia added $12,000 to an account that will grow tax free and allow her to withdrawal the principal and growth of those funds tax free in retirement. If Amelia earns 6% annually on that $12,000 over 35 years, she ends up with more than $92,000 extra in her Roth IRA that grew tax free and which she can withdraw 100% tax free! That’s good planning.

In our next installation of the IRA Tool Chest Series, we’ll discuss how to use a Roth IRA to save for college.  

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Portfolio Solutions® does not provide tax advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax advice. You should consult your own tax advisor before engaging in any transaction.