Here are some caveats to follow when using a Roth IRA as an emergency fund:
Leave Roth earnings alone
Withdrawing contributions is simple, but withdrawing Roth earnings -- dividends and capital gains -- is trickier. Avoid doing so if you can or check with your tax professional first.
You would have to request the withdrawal through your brokerage, bank or mutual fund, and the firm will know whether you are eating into earnings, Keener says.
Why does it matter? If you withdraw earnings without doing what the IRS considers a "qualified distribution," you will pay a 10% tax penalty plus regular income taxes on the money, says Keener. Depending on your tax bracket, you could immediately give up almost half of that money to the IRS in taxes and penalties.
You may have heard of a "5-year rule" regarding Roth earnings. In short, after 5 years of opening a Roth, you can withdraw earnings tax-free if you meet any of 9 "special case" criteria, including these common ones:
- You are at least 59 1/2 years old.
- The distribution is due to death or disability.
- The distribution is made to a qualified first-time homebuyer (the funds must be used within 120 days of withdrawal).
Converted Roth IRAs are different from regular Roths
You can't withdraw contributions from a converted Roth any time without a penalty as you can with a regular Roth. Instead, you must wait 5 years. As such, it's better to use a regular Roth for your backup emergency fund, says Keener.
Use Roth withdrawals for true emergencies
Don't be tempted to dip into your Roth for vacations or other nonessentials. For one thing, you can't simply "return" the money later. Any money you put back into your Roth is considered part of your allowed contribution for that particular year.
For example, she says, if you're allowed to contribute $5,500 a year to your Roth, you can't put in $5,500 plus the $2,000 that you withdrew at an earlier date. You can contribute the $5,500 and that's it.
Perhaps more important, when you withdraw money from your Roth, you lose the benefit of having the money grow tax-free over many years. And that's why you opened your Roth in the first place.