Split emergency savings fund, invest half?
Dear Dr. Don,
I am in my early 30s with a young family. Is it a good idea to put up to half of my rainy-day fund into my Roth individual retirement account? What can go wrong if half is in cash for quick access and the other half is in the retirement account ready to pull out if needed? Obviously, not all the money saved into the Roth will be for the emergency fund, but it doesn't make sense to me to keep all money that may or may not be needed on the sidelines.
-- Greg Go-Long
The idea behind an emergency fund is to have three to six months' worth of savings readily available for a financial emergency such as losing your job or needing a major household repair. Having that money liquid saves you from having to dip into less-liquid investments and potentially having to take a loss on an investment to free up funds.
In an ideal world, you'd never need to tap your emergency fund, so consumers view the idea of having that much money earning a low yield in a savings account as a drag on their investment returns.
You contribute after-tax dollars to a Roth IRA. The withdrawal of your contributions prior to retirement doesn't create a tax obligation. But if you withdraw the account's investment earnings before age 59 ½ and the withdrawal is not considered a qualified distribution, you're likely to owe taxes, including a 10 percent penalty tax. There's also a seasoning requirement for Roth IRAs that requires the account to be funded for five years before money out of the account can be considered a qualified distribution.
You can make your strategy of placing half your emergency fund in a Roth IRA work, but it doesn't get around a liquidity issue related to how that account is invested. If you have the money in the stock market, you could be forced to take a big hit on your investment if it's trading at a lower price when you need to take cash out of the account.
Series I savings bonds can be a decent alternative to the Roth IRA for the emergency fund, especially if you expect you will be able to use the bonds' education tax exclusion if you redeem them when your children go to college. The downside is you can't redeem the bonds in the first year you own them, and there's a three-month interest penalty for early withdrawal if you redeem them in years one through five.
The risk comes if you need the money in the first year or if your income is too high when the children are of college age for you to take advantage of the education tax exclusion. You can manage part of that risk by planning not to use the savings bonds for the emergency fund during the first year you own them.
Even if you don't use the bonds to fund the children's qualified college expenses, you can defer income tax on their interest earnings until the bonds are redeemed or mature. It's not quite the same as the tax-free return on qualified distributions in retirement that the Roth IRA offers, but it is an inflation-protected, tax-free strategy if you expect to be able to use the savings bonds' education tax exclusion.
Yet another strategy is to invest your emergency fund in five-year certificates of deposit and accept the risk that you'll have to pay an early withdrawal penalty if you have to cash them out early for an emergency. The CDs wouldn't offer the tax benefits of the Roth IRA or the savings bonds for education, but they would provide an alternative to keeping your emergency fund in low-yielding, short-term money market accounts.
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