Using a Roth IRA As Your Emergency Fund

With the economy in bad shape, and the number of layoffs rising, people are starting to ask difficult questions.  Will Barack Obama’s upcoming presidency change anything?  Can I still retire?  What should I do with my investments?  And, perhaps even more difficult, what do I do if I have to cash in some of my IRAs?

Roth IRA Emergency Fund

help In years past, some financial journalists and other professionals have advocated using a Roth IRA as an emergency fund.  Now, that chicken is coming home to roost and the questions abound.  Just how can I use my Roth IRA as my cash reserve, because I need to access those reserves now?

The theory behind the Roth IRA reserve is that the contributions made to a Roth IRA are made with post-tax dollars.  Because if this, they can be withdrawn at any time without additional taxes or penalties.  (You already paid taxes on that money.)  As always, the devil is in the details.

While the IRS will graciously allow you to withdraw your invested capital without penalty, the same may not be true of the companies that money has been invested with.  For example, if you bought mutual funds with a back-end load, or worse, an annuity with a steep surrender charge over a long time period, there is still going to be a penalty, it just won’t be from the tax guys.

If you purchased A shares, or front-load, mutual funds, there won’t be a penalty per se when you withdraw your money, but you might still be paying one.  When an investor purchases front-end loaded mutual funds they pay an upfront fee on the original investment in exchange for lower ongoing mutual fund expenses.  However, like a refinanced mortgage, it takes time for the lower expense ratio to pay for itself to make up the original expense of the load.

As an example, if you invested $50,000 in a mutual fund with a 5% front-load and in doing so got an expense ratio that was 1% less than the equivalent no-load mutual fund, then the original sales charge was $2,500.  That one percent savings on the expense ratio works out to $500 per year in savings.  (This is for example purposes only.  The actual amount of savings would vary dramatically based upon the performance of the fund, this example assumes a constant value for the sake of illustration.  Things would be worse if the fund has been losing value and better if the fund has been increasing in value.)

In other words, if it hasn’t been 5 years since you bought the fun, you are still “behind” where you would have been had you not paid the load.  So while the Feds won’t be looking for any of your money, you still are taking a hit.

And, there is another important consideration.  While you may be entitled to take out $15,000 worth of contributions that you made over the last several years, you will never be entitled to return the $15,000 to your Roth IRA when the emergency is over.  There is still an annual contribution limit regardless of whether you withdraw any funds or not.  That means that the most money you can put back in 2009 is $5,000 (unless eligible for the catch-up contribution.)

For Real Emergencies Only

In other words, while there is some ability to withdraw from a Roth IRA without tax penalty, such an option should only be used in real emergencies.  Remodeling your kitchen, or paying off some credit cards that you can still make payments on, are not emergencies.  A choice between foreclosure or pulling money from your Roth IRA is a real emergency.

Be smart.  Times are tough, but that is when people make mistakes that cost them dearly.  Think clearly and do your research first, and you’ll be fine.

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