How to Use Your Roth IRA As an Emergency Fund

Contributing to a tax-advantaged retirement account comes with rules that make it difficult to get your hands on your cash should you suddenly need it. Understandably, these controls are one reason people can feel reluctant to fund an individual retirement account (IRA) or 401(k) plan to the max each year, even though they know that the earlier they invest, the greater the chance that their funds will have to grow at tax-free compounded rates.

The desire to save for retirement gets overruled by the need to maintain an emergency fund of easily accessible money, be it for car repairs, medical bills, a job loss, or an economic crisis; however, few people are aware that an often-overlooked feature of the Roth IRA could solve this problem—allowing you to have your cake and invest it, too. It sounds unlikely, but it’s actually true.

Quick Recap: Roth IRA Rules

A Roth IRA is a retirement savings account that allows qualified distributions on a tax-free basis as long as certain conditions are met. Although Roth IRAs are similar to traditional IRAs, their tax treatment by the Internal Revenue Service (IRS) is quite different.

Unlike contributions to traditional IRAs, Roth IRA deposits don’t get you a tax deduction when you make them. In IRS lingo, they’re paid for with after-tax dollars. The money in the account grows tax-free until it’s withdrawn. And when you retire, you pay no taxes on withdrawals because you already paid income taxes on the money with which you made the deposits. With a traditional IRA, you pay income taxes on withdrawals in retirement.

Roth IRA account owners don’t have to take required minimum distributions (RMDs). An RMD is a minimum amount, as established by the IRS, that must be withdrawn from a traditional IRA and a defined-contribution plan each year once you reach a certain age. If you were born between 1951 and 1959, the age is 73. If you were born in 1960 or after, the age is 75. This is an increase from the previous age of 72.

Roth IRA Contribution Limits

A Roth IRA allows you to contribute $6,000 for 2022 and $6,500 for 2023. If you’re married, you and your spouse can each contribute $6,500 for a total of $13,000. Each individual is allowed to contribute an additional $1,000—called a catch-up contribution—if aged 50 or older.

Roth IRA Income Limits

There are also limitations on how much you can earn and still qualify for a Roth. The income limits are adjusted each year by the IRS. These are the limits for the 2022 and 2023 tax years based on your income and tax filing status:

• For the 2022 tax year, if you’re married and file a joint tax return, the phaseout begins at a modified adjusted gross income (MAGI) of $204,000. If you make more than $214,000, you aren’t eligible for a Roth. Single filers hit the threshold at $129,000 and are disqualified if their incomes exceed $144,000.
• For the 2023 tax year, if you’re married and file a joint tax return, the phaseout begins at a MAGI of $218,000. If you make more than $228,000, you aren’t eligible for a Roth. Single filers hit the threshold at $138,000 and are disqualified if their incomes exceed $153,000.

Roth IRA Withdrawals

You often hear that Roth IRA withdrawals are tax-free. Although that’s true, it is complicated. Not all withdrawals are created equal in the eyes of the IRS.

When filing your tax returns, you don’t include in your gross (taxable) income any distributions that are a return of your regular contributions from your Roth IRA(s). Because contributions to a Roth are made with funds on which you’ve already paid taxes, IRS rules allow you to withdraw that money (or strictly speaking, the same amount of money) without owing any more tax on it.

But any sums that accrued in the account above and beyond what you originally deposited are a different story. For those, you have to wait until after the five-year period beginning with the first tax year for which a contribution was made to the Roth IRA to begin making withdrawals. If you don’t wait, such withdrawals are subject to taxes and a penalty if you’re under the age of 59½.

In other words, the contributions can be withdrawn at any time without penalty or taxes; however, investment earnings generated from your deposits—interest income, dividends, capital gains—must remain in the account for at least five years, and ideally until you’re at least 59½ to avoid incurring a 10% penalty and taxes.

The good news is, Roth withdrawals are made on a first-in, first-out (FIFO) basis. So any withdrawals are initially classified as coming from contributions. Earnings aren’t considered touched until a sum equal to all the contributions you’ve made has been reached.

The Roth IRA as an Emergency Fund

The advantage of putting emergency savings into a Roth IRA is that you don’t miss the limited opportunity to make that year’s retirement contribution. You can only contribute a few thousand dollars to a Roth IRA each year, and once a year passes without a contribution, you lose the opportunity to make it forever; however, accessing these funds should be your last resort.

Matt Becker, a fee-only certified financial planner (CFP) who runs the site Mom and Dad Money, points out that you don’t want to withdraw Roth IRA contributions for minor emergencies, such as car repairs or small medical bills. You should keep enough in savings for those events. Your Roth IRA emergency fund should be for larger emergencies, such as unemployment or a serious illness; however, for some, withdrawing Roth contributions might be a better option than racking up interest charges on credit card balances.

Structuring the Roth IRA for Emergencies

The key to using a Roth IRA as an emergency fund is to limit distributions to contributions. In other words, don’t start dipping into investment earnings. It’s important to note that IRA funds aren’t labeled “contributions” and “earnings” on your statement. So, just follow this simple rule: Don’t withdraw more than you have deposited.

The part of your Roth IRA contribution earmarked as your emergency fund doesn’t belong in stocks, bonds, or mutual funds like a typical retirement contribution. It belongs in a liquid account (meaning cash or something that can easily be converted to cash and that earns interest) that can be withdrawn from at a moment’s notice without losing principal.

“It is critical not to invest the portion of your Roth dedicated to your emergency fund,” says Garrett M. Prom, founder of Prominent Financial Planning in Austin, Texas. “This money is for emergencies, which in most cases is job loss. If that job loss is part of a downturn in the economy, you will have to sell investments, usually at a loss.”

Gains to the Roth account will increase without you paying taxes on the earnings every year, as would be the case with a regular savings account. You also won’t pay taxes on these earnings when you withdraw them as qualified distributions once you reach retirement age.

A so-called savings account within a Roth can earn at least as much interest as a regular savings account, if not more, depending on where you bank. If you already have a Roth IRA, but your financial institution doesn’t have any low-risk, interest-paying options for your money, open a second Roth IRA at an institution that does.

Once you have a large enough emergency fund, start moving some of those contributions into higher-earning investments. You don’t want all of your Roth contributions in cash forever. This process might take you a few months or a few years, depending on how quickly you accumulate additional savings.

Withdrawing Rolled-Over Roth Funds

If your Roth IRA contains contributions that you converted or rolled over from another retirement account, such as a 401(k) from a former employer, you’ll need to be careful about any withdrawals. There are special rules about withdrawing rollover contributions. Unless they’ve been in your Roth for at least five years, you’ll incur a 10% penalty if you withdraw them. Each conversion or rollover has a separate five-year waiting period.

Withdrawing rollover contributions penalty-free can be tricky. It’s a good idea to consult a tax professional if you find yourself in this situation.

The good news is that if you have both regular contributions and rollover contributions, the IRS first categorizes withdrawals as withdrawals of regular contributions before it categorizes them as withdrawals of a rollover contribution.

How to Withdraw Roth Funds

The availability of funds may differ, depending on the institution where you keep your Roth and the type of account in which you place the money. When you need money urgently, you don’t want to hear that it will take days to get a check or bank transfer. Before you make a contribution to your Roth IRA, find out how long distributions take.

Funds can typically be retrieved in fewer than three business days. If you wish to take funds out of a money market or mutual fund and you put in your withdrawal request before 4 p.m. EST, you may have the money by the next business day.

If the money is invested in stocks, you will typically need to wait three business days, although if you have a checking account with the same institution where you have your Roth IRA, you may be able to get it faster.

A wire transfer can also be a fast way to access funds, though you’ll have to pay a fee that typically runs from $25 to $30. “Most brokerage firms can wire funds directly from a Roth IRA to a checking or savings account in one business day, assuming stocks or bonds don’t have to be sold to generate cash,” says accredited asset management specialist Marcus Dickerson of Beaumont, Texas.

These potential delays in Roth IRA funds availability are another reason to keep some emergency cash outside of your Roth IRA in a checking or savings account for extremely urgent needs.

File the Correct Tax Forms

You don’t need to report Roth IRA contributions on your tax return as they don’t affect your taxable income; however, if you do need to withdraw contributions from your Roth IRA to use in an emergency, paperwork is involved. Even though they’re allowed, you still have to report your withdrawals on Part III of IRS Form 8606.

If you use tax preparation software, it will ask you if you made any withdrawals from a retirement account during the year and guide you through the paperwork. If you use a professional tax preparer, make sure Form 8606 is included in your return.

If you only put money in your Roth and don’t take anything out, you have nothing extra to do at tax time. Also, if you make your Roth contribution before the income tax filing deadline for the year and need to withdraw that money before the filing deadline, the IRS treats these contributions as if you had never made them. You won’t need to report them at tax time.

Return Withdrawn Funds

If you do have to withdraw contributions, you can pay yourself back and retain your Roth contribution for that year if you act fast. “If the emergency turns out to be a short-term cash-flow issue that gets resolved quickly, [you] can put the money back into the Roth IRA . . . to refund this account,” says certified financial planner Scott W. O’Brien, director of wealth management for WorthPointe Wealth Management in Austin, Texas.

Do that and the most you’ll lose is a little bit of interest. You probably won’t even have to report the withdrawal.

The upshot is, if you withdraw contributions made during the current tax year, you have until the tax deadline (April 15 of the following year) to redeposit the money in your Roth IRA.

But if you withdraw more than you can contribute in a year, you cannot re-contribute 100% of those funds during the same year. You can only put back your contribution limit every year. This is why it is a bad idea to rely on your Roth IRA for emergency funds. Unless you can pay back the whole amount within the year, you’ll lose many years of compound interest on the funds you take out. Moreover, because of the contribution limits it may take you many years to rebuild your account balance.

Redeposit Scenarios

Let’s look at some examples for clarity. Check with a tax expert to be sure these apply to you and if there are any exceptions or changes to the rules.

Example 1

You’ve got $30,000 in a Roth IRA. You’ve contributed $20,000 in prior tax years and $6,000 in 2022. The remaining $4,000 has come from investment growth (earnings). If you withdraw $6,000 worth of contributions in 2022, you have until April 2023 to re-contribute those funds back into the Roth IRA.

By withdrawing your contributions from 2022, it is like your contribution never happened. Your Roth IRA contributions toward the limit are reset back to $0. If April 18, 2023 passes and you haven’t contributed $6,000 back into the Roth IRA, then you won’t get to make a 2022 contribution at all.

Example 2

Same situation: $30,000 in the Roth, $20,000 from the prior year’s contributions, $6,000 contributed in 2022, and $4,000 in growth. You withdraw $2,000 of contributions. You have until April 2023 to contribute another $2,000 or your Roth IRA contribution for 2022 will only be $4,000.

Example 3

Same situation, but this time you withdraw $10,000. That means you’ve taken out your $6,000 in contributions from 2022, as well as $4,000 of prior contributions. You cannot re-contribute the full $10,000 in 2022. You can only contribute up to your annual maximum of $6,000.

You can then use the remaining withdrawal of $4,000 as a contribution to your Roth IRA in the next year, plus $2,500 more to bring it up to the $6,500 2023 contribution limit. That means you can’t add another $6,000 for the year because you re-contributed the $4,000 that you withdrew in the prior year.

To borrow effectively from your Roth IRA, you would need to have already contributed earlier in the year, withdrawn that contribution, and paid it back before tax time the following year.

There is no formal loan program with a Roth IRA as there is with a 401(k) plan.

The Bottom Line

Since a Roth account is one of the most flexible retirement accounts available, it can double as an emergency fund. It can give you a sense of security knowing that, if you need it, you have penalty-free access to any of the contributions that you made to the account over the years. And if you wait long enough, you’ll get penalty-free and tax-free access to the account’s earnings as well.

Just make sure you check the rules regarding what is available as tax-free and penalty-free withdrawals. Ideally, you should repay the money quickly or you’ll miss out on years of tax-free compounding growth.