Golden Roth IRA egg on money © iStock

If you want to maximize your retirement contributions, but also want to tuck away money in an emergency fund, you could use a Roth IRA to pull off both.

An often-forgotten benefit of the Roth IRA is that you can withdraw from your own contributions any time, without a tax or penalty. You paid tax on that money before it went into your IRA so there’s no additional tax or penalty to withdraw it, says Jean Keener, CFP professional and a Chartered Retirement Planning Counselor (CRPC) in Keller, Texas.

First, it’s still smart to have some cash readily available in a savings account for small emergencies, like a roof leak or car repair, suggests Keener. After that, consider parking additional rainy-day money in your Roth IRA to let that money grow tax-free for retirement as well as play a supporting role as a backup emergency fund.

“If you plan to use your Roth as part of your emergency fund, you would invest it differently than money for retirement,” says Keener. “It should be in safe investment vehicles like money market funds, CDs and short-term bonds so you won’t suffer investment losses if you need to tap the money when the market is down.”

You don’t need a separate Roth for your emergency funds; consider them a separate “bucket” within your larger Roth account, says Keener.

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:

  1. You are at least 59 1/2 years old.
  2. The distribution is due to death or disability.
  3. 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.

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