Why You Shouldn’t Use a Roth IRA as an Emergency Fund

Nadine writes in:

Does it make sense to use a Roth IRA as an emergency fund? It seems like I could contribute money to it, have it build tax free for a while, then I take out the contributions in an emergency and just keep those earnings for retirement. Why not do this?

Well, as you can see from the title of this article, I don’t actually think this is a very good idea. While Nadine’s point is accurate – you can, in fact, withdraw your contributions from a Roth IRA without penalty and just allow the earnings to build – that’s a really bad idea outside of an absolute emergency.

Here’s why.

Reason #1: You Lose Most of Your Retirement Gains

Let’s say you contribute $5,000 at age 25 and decide that you’re going to leave it in there until age 65. You put it into a hypothetical investment that earns 7% per year.

You check that account at age 65 and what’s in there? $74,872. Sweet!

Now, let’s look at an alternate scenario. You put $5,000 in there at age 25, just as before, but then you withdraw your $5,000 contribution at age 30 because of an emergency. What happens then?

Well, you peek in there at age 65 and… you have $21,489. Wow.

Because you took out that original $5,000 at age 30, you lost $48,382 in investment growth in that account. You tossed away what amounts to most of a year of living expenses (depending on inflation).

Here’s the core principle to remember here: If you withdraw your contributions early from your Roth IRA, you give up a lot of tax-free growth.

“But can’t I contribute more later to put the money back?” Unfortunately, no.

Reason #2: You Lose Your Contribution Window, Too

As of right now, each year, a person is allowed to contribute $5,500 to a Roth IRA (or $6,500 if they’re over age 50), provided their income makes them eligible (most Americans are). Once you reach that limit for a given year, you can’t contribute any more.

Furthermore, once a year passes by, you lose that contribution window. You can no longer make contributions for 2013 or 2014 or 2015. The calendar keeps marching forward, and as it does, you lose out on opportunities to contribute to your Roth IRA.

Those contribution windows are valuable. You only have so many windows to contribute during your working career. Between the ages of 25 and 65, you basically have 40 such windows (and that assumes that you’re within income limits on all of them).

So, let’s say you withdraw $10,000 in contributions from your Roth IRA. That’s the equivalent of just throwing away two of those contribution windows. You can never, ever get them back. They’re gone forever. You’ve effectively permanently reduced the amount you can ever contribute to your Roth IRA by $10,000.

Let’s put that in perspective. From ages 25 to 50, you have a total of $137,500 in contribution windows, and from 50 to 65, you can contribute a total of $97,500, giving you a total of $235,000 in contribution windows. You can only ever contribute that much to your Roth between 25 and 65, period.

Whenever you choose not to contribute up to the cap in a given year, you lose some of that total window. Didn’t contribute for the first five years? You can only ever contribute $207,500 total, because those first five years are lost. Only contributed $1,000 a year for the first decade? You threw away $45,000 of contribution windows that you’ll never get back.

The same thing is true when you withdraw your contributions. You’re effectively losing a contribution window you can never get back. If you contributed $5,000 when you’re 25 and then take that money back out when you’re 30, you’re not going to “gain back” the opportunity to contribute more. You’ve not only taken $5,000 out of that account, but you’ve lost some of the total that you’ll ever be able to contribute to the account. You can’t just put the $5,000 back without eating your current contribution window. The old one is gone forever.

What if you want to “make up” that $5,000 withdrawal later? You can, but by doing so, you’re effectively gobbling up a later contribution window. If you withdraw $5,000 in 2017 and then decide to put it back in 2020, you’re eating up $5,000 of your 2020 contribution window, leaving you with only $500 in fresh contributions that year.

Here’s the core principle: Your contribution windows are a limited resource, and withdrawing your contributions wastes those contribution windows. This might not be a big deal if you’re not using your Roth IRA to its full extent… but if you’re not using every drop of that Roth IRA contribution window, you may be making a mistake anyway (that gets into retirement planning issues that are outside the scope of this article).

There’s a final reason why simply taking money out of a Roth IRA to solve a problem might be a bad idea…

Reason #3: You’re Taking an ‘Easy Way Out’ of Your Financial Situation

When a financial emergency occurs, it’s often easiest to simply look for available pools of money and use those to solve the problem and then move on with life. The problem, of course, is that this really doesn’t solve the problem at all. The short-term problem – whatever the crisis of the moment is – is solved, but you’re left with a big, ongoing, long-term problem – a lifestyle that’s stretching your means – along with a new problem – a reduction in your retirement savings.

In short, if you’re tapping your Roth IRA in an emergency, you’re introducing a new long-term problem without really solving the one that already exists. Sure, you’re getting rid of the short-term issue, but you’re facing a lifestyle that’s pushing your means to sustain it while also facing a retirement for which you’ve just tapped some of your savings.

What’s the solution, then? First of all, if you’re in an emergency where tapping your Roth seems like a good solution, use other resources instead. Leave that Roth alone and try to find a different way to solve that challenge. Your Roth should be your last resort.

When the immediate crisis passes, step back and take a deeper look at your life. If you’re making financial choices that led to you considering tapping out your Roth, you may want to consider different choices.

Are you spending less than you earn? If you’re not doing this, you are going to constantly run into financial trouble in your life. There are simply times in the course of life where you are going to have more financial demands than you expect and it’s during those moments that you need to draw on your resources. If you aren’t preparing for this constantly during the easy times, the hard times are going to be very hard, indeed. As is often noted, winter is coming.

Do you have an actual emergency fund, one that’s large enough to handle most major emergencies? Do you have a pool of cash on hand that could help you bear the brunt of a sudden job loss? What about the transmission failing in your car? What about both? What about a sudden death in the family that necessitates emergency travel? What about identity theft that causes your accounts to be stolen and your credit cards to be closed? These things can and do happen. Are you prepared for them?

Are you earning up to your potential? In other words, are you doing everything you can to succeed in your career so that you can easily move on to higher paying jobs and pull in more income? This is perhaps the most important aspect of all if you’re struggling to spend less than you earn and are only covering the bare necessities. The only way out of that conundrum is to improve your earnings and that requires a serious focus on your career.

The key thing to remember is this: a situation where you’re even considering pulling contributions out of your Roth IRA is an indication that you’re living a life that’s full of financial missteps. You’re likely spending as much as you earn (or nearly as much). You likely don’t have an emergency fund, either. Part of this might be fueled by a job that doesn’t pay well, which is another thing that you can be working on. Correct those missteps. That desire to tap your Roth IRA is a warning shot.

Some Final Thoughts

First of all, if you’re ever in a position to even consider tapping your Roth IRA in an emergency, you need to step back and take a bigger look at your finances. Your Roth IRA is for retirement; if you use it in an emergency, you’re damaging your retirement savings plans. Instead, you should have other emergency protections in your life – namely, a cash emergency fund.

If you’re in this situation, start by considering all other options first. Have you investigated other methods of paying down debt? Do you have some unused belongings you could sell to pay for the emergency? Can you borrow something for a while, such as borrowing a ride or a car for a few days until you figure things out? Is there an alternate strategy you can use for a while, like using the bus instead of your car?

Your Roth IRA should be your emergency fund of absolute last resort. You don’t just lose the contributions from your retirement savings, you also lose the many years of earnings that those savings will generate and you lose some of your window of opportunity to contribute to your Roth IRA. It’s not worth it.

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