Roth IRA’s are the darling of retirement savings. Contributions are not tax-deductible, however, the money in the account grows tax-free and can be taken out tax-free at age 59 ½.
Most advisors only use Roth IRAs for tax diversification in retirement. For new savers, we recommend using this account as a pool of emergency funds. Using the Roth IRA as an emergency savings vehicle creates a liquid source of funds while also creating a pool of money that will have tax advantages later if it remains untapped.
How do I setup a Roth as an emergency funds account?
First, you need to establish two separate Roth IRAs. The first Roth IRA should be funded to meet your emergency needs. Generally, this is 3-6 months of your spending needs depending on the stability of your job. Keep this Roth IRA money invested in a money market or cash investment so that it bears no investment risk.
As your emergency needs increase, you can contribute more to your emergency Roth. However, if your emergency needs decrease or if you start to accumulate money in other accounts that can be used for emergency needs, you can take some of the Roth emergency savings and move them to the second Roth IRA.
The second Roth IRA should be established for investing and retirement savings. You should only contribute to this retirement Roth IRA when you have fully funded your emergency Roth.
You can implement both strategies inside a single Roth IRA, but it is much easier to manage two different strategies if you have separate Roth IRA accounts. By having two accounts, you are creating an objective for each account and you can appropriately tailor the account for that goal.
Why not just use a savings account?
The Roth IRA can accomplish everything a savings account can while also giving you tax benefits if you don’t end up utilizing the emergency funds. Roth IRA contributions are very accessible: you can take out from a Roth IRA the amount of money that you put in without any tax consequences.
For example, let’s say you put $3,000 into a Roth IRA for three years and at the end of the third year the account was worth $9,180 because you received interest income. You can take out $9,000 at any time without any tax consequences.
The main goal of an emergency Roth is for you to achieve financial security while utilizing the contribution limit as much as you can. Roth IRA contributions are limited to $5,500 a year with an additional “catch-up” contribution of $1,000 if you are older than 50.
This means that someone who starts working at 24 and retires at age 62 will only be able to contribute a total of $221,000 to their Roth IRA over their lifetime if they contribute the maximum each year.
Note: There are also further limitations on Roth contributions based on income that can disqualify you from contributing in certain years.
When should I put money into my non-emergency Roth IRA?
This depends on several aspects of your financial life. Ultimately, it depends on finding the biggest benefit for your savings. Our article on the “waterfall approach” to retirement savings focuses on where you should save your money based on the benefits of different savings accounts. We recommend focusing savings into your Roth IRA when you believe your tax bracket now is the same or lower than what it will be when you need the money.
Roth IRA growth and the 5-year rule
While all contributions can be taken out tax-free, the investment growth of the Roth IRA has different rules to follow to avoid paying tax on the distributions.
The first rule is that growth will be subject to income tax if five years have not passed since the first contribution to the account was made. In the prior example, this would mean that the $180 of interest income inside of the Roth would be subject to income tax since the individual made their first contribution only three years ago.
The second rule regarding Roth IRA growth is that there will be a 10% penalty tax for all non-qualified distributions before the age of 59 ½. There are three main exceptions that allow you to receive qualified distributions before age 59 ½: a first time home purchase (up to $10,000), disability, or death.
We would love to meet with you to see if setting up an emergency and non-emergency Roth IRA are the right strategies for your financial situation. We can help you navigate the complicated tax rules regarding distributions while setting you up for success in retirement.