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. These controls are one reason people can feel understandably reluctant to fund an individual retirement account (IRA) or 401(k) plan to the max each year, even though they know the earlier they invest, the greater the advantage 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 a crisis such as the coronavirus pandemic has visited on the world.
Know 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.
- Because you can withdraw contributed sums at any time without taxes or penalties, a Roth IRA can double as an emergency savings account.
- Roth funds should only be withdrawn as a last resort.
- When withdrawing funds, be sure to limit the sum to your contributions; don't dip into earnings, or you generally will be penalized.
- In 2020, due to the coronavirus stimulus bill, you can withdraw as much as $100,000 from either type of IRA (Roth or traditional) without a 10% early withdrawal penalty if you have been affected by COVID-19.
- You can redeposit withdrawals from a Roth, preferably within 60 days—or at the latest, before the tax filing deadline for that year.
- No matter how much you withdraw, you can only redeposit a sum up to the current Roth IRA contribution limit for the year.
Quick Recap: Roth IRA Rules
There are limitations on how much you can earn to qualify for a Roth.
The income limits are adjusted each year by the Internal Revenue Service (IRS). These are the limits for the 2019 and 2020 tax years:
- For the 2019 tax year, your ability to contribute is phased out if you are married filing jointly and make a modified adjusted gross income (MAGI) of $193,000 to $203,000. If you make more than $203,000, you aren't eligible for a Roth. Single filers hit the reduced contribution threshold at $122,000 and are disqualified once their income exceeds $137,000.
- For the 2020 tax year, the phase-out begins at a modified adjusted gross income (MAGI) of $196,000. If you make more than $206,000, you aren't eligible for a Roth. Single filers hit the threshold at $124,000 and are disqualified if their incomes exceed $139,000.
If you do qualify, a Roth IRA allows you to save as much as $6,000 per year in 2019 and 2020. If you’re married, you and your spouse can each contribute $6,000 for a
total of $12,000. Add $1,000 per person if either or both of you are age 50 or older.
Unlike contributions to traditional IRAs, Roth IRA deposits don't get you a tax deduction when you make them. In IRS lingo, they're done with after-tax dollars. The money in the account grows tax-free until retirement. And when you retire, you pay no taxes on withdrawals—because you effectively did that when you made the deposits.
You also won’t be mandated to take required minimum distributions (RMDs) from that account. The money can continue to grow tax-free until you need it.
(With a traditional IRA, you pay taxes on withdrawals and you are required to take out a certain amount after age 72. Note that RMDs were suspended for 2020 as part of the coronavirus stimulus bill.)
You have 15½ months each tax year to accumulate emergency funds to place in a Roth. For example, for the tax year 2020, you can make contributions from Jan. 1, 2020, through April 15, 2021.
Now for the good part. Because contributions to a Roth are made with funds on which you’ve already paid taxes, IRS rules allow you to withdraw that money—the sum of your contributions, in other words—at any time without penalty or taxes.
Only investment earnings generated by your deposits—interest income, dividends, capital gains—must remain in the account until you’re 59½ to avoid paying a 10% penalty.
“Roth IRAs remain the most flexible retirement accounts in the country,” says Jeff S. Vollmer, managing director of Hyde Park Wealth Management in Cincinnati.
So, in effect, your Roth account can double as an emergency savings account. It can give you the safety of knowing that, if you need it, you have penalty-free access to a key part of these savings.
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.
Accessing these funds, however, should be your last resort.
Matt Becker, a fee-only certified financial planner who runs the site momanddadmoney.com, 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.
Withdrawing Roth contributions is 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. Don’t start dipping into investment earnings.
Admittedly, IRA funds aren’t labeled “contributions” and “earnings” on your statement. Still, following this rule is simple: Don’t withdraw more than you’ve put in.
“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.”
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 that still earns a bit of interest, but one from which you can withdraw at a moment’s notice without losing principal. Ally Bank, for example, has an IRA savings account that paid 1.50% interest, as of March 2020.
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.
While the IRS calls early emergency withdrawals “unqualified,” which makes it sound like you’re breaking a rule, “qualified” distributions are simply those that have been in your Roth for at least five years and that you withdraw after age 59½.
A 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 brokerage doesn’t have any low-risk places to keep your money while still earning interest, open a second Roth IRA at an institution that does.
Once you have a large enough emergency fund, start moving 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 can 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 because 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, and 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. Penalty-free withdrawals of $100,000 are allowed under temporarily loosened rules under the coronavirus stimulus bill, but check carefully to make sure you qualify.
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 rollover contributions.
How to Withdraw Roth Funds
Fund availability 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 making 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 are taking funds out of a money market or mutual fund and you put in your withdrawal request before 4 p.m. EST, you will have the money by the next business day.
If the money is invested in stocks, you will need to wait three business days typically, 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 $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 fund availability are another reason to keep some emergency cash outside of your Roth IRA in a checking or savings account for extremely urgent needs.
Fill Out 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, there’s paperwork involved. Even though you’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 (July 15, 2020, for 2019 taxes, due to the coronavirus situation) 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.
Can You 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 within 60 days 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.
However, if you need to, you can extend the deadline a bit. If you withdraw contributions made during the current tax year, you have until the end of that tax deadline (April 15 of the following year) to redeposit the money in your Roth IRA. If you withdraw contributions made in other years, you can redeposit up to your contribution limit by the end of the tax deadline.
However, 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.
The maximum contribution to a Roth IRA in 2020; there's an additional $1,000 catch-up deposit allowed for those 50 and over.
Redeposited Roth Funds Scenarios
Let’s look at some examples for clarity. These examples are for normal years and may be different in 2020 under the special rules for the pandemic period. Check with a tax expert to be sure.
You’ve got $30,000 in a Roth IRA. You’ve contributed $20,000 in prior tax years and $6,000 this year, 2020. The remaining $4,000 has come from investment growth (earnings). If you withdraw $6,000 worth of contributions from this year, you have until April 2021 to re-contribute those funds back into the Roth IRA.
Essentially, by withdrawing your contributions from this year, it is like your contribution never happened. Your Roth IRA contributions toward the limit are reset back to $0. If you go past April 15, 2021, and haven’t contributed $6,000 back into the Roth IRA, then you won’t get to make a 2020 contribution at all.
Same situation: $30,000 in the Roth, $20,000 from prior year contributions, $6,000 contributed this year, and $4,000 in growth. You withdraw $2,000 of contributions. You have until April 2021 to contribute another $2,000, or your Roth IRA contribution for 2020 will only be $4,000.
Same situation, but this time you withdraw $10,000. That means you’ve taken out your $6,000 in contributions from this tax year, as well as $4,000 from the past. You cannot re-contribute the full $10,000 this year. You can only contribute up to your annual maximum of $6,000.
There is no way to put the entire $10,000 back into the Roth IRA other than contributing the remaining $4,000 to your Roth IRA in the next tax year, plus $2,000 more to bring it up to $6,000. (But then, one hopes, you were already budgeting to invest another $6,000—which you now wouldn’t be able to do.) To effectively borrow 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.