Everyone has limited resources and unlimited wants, and one of the most common questions is whether to add to an emergency fund or contribute to a Roth IRA. While the answer varies from person to person, for most people, contributing to a Roth IRA is usually the better move. The reason for this has everything to do with the nature of the Roth IRA.
Contributions are Tax and Penalty Free
With a Roth IRA, your contributions can be withdrawn tax and penalty free. When the Roth was created in 1998, legislators wanted to be sure greater flexibility was afforded to Americans in an effort to increase retirement readiness. The result was a retirement account that included liquidity features that were far better than its predecessor, the Traditional IRA.
Cash is King
Though you might think of a Roth IRA as an investment, it's really just a type of account. What you hold in this account is up to you. If you are short on your emergency fund and retirement savings, the best bet is to contribute to a Roth IRA, but keep the money in cash. The reason for this is when an emergency comes up, you won't have to take money out when the market is down (more emergencies come up when the market is down than when it is up).
Preserving Tax Benefits
Investing in cash isn't exciting and it likely won't take you much closer to your retirement goals. However, it does preserve your tax break. Roth IRA withdrawals are completely tax free during retirement, and even if you don't invest it in higher yielding assets like stocks or bonds, the tax break will be preserved. As your financial situation improves and your emergency fund grows, you can start investing more aggressively.
Application: Roth IRA in Cash
Let's say that Jane needs an emergency fund of $15,000, but currently has $3,000 set aside. She can save up to $300 per month and decides to put this money into a Roth IRA. After three years, an emergency comes up and she needs to pull out $5,000. She can do so without penalty or taxes from the Roth IRA whose balance is just north of $10,800. She takes $5,000 out, no penalty or taxes are paid, and the emergency is taken care of.
Application: Roth IRA in Stocks
Wild Bill loves playing the stock market. He, just like Jane, needs $15,000 set aside, has $3,000 in reserve, and can save $300 per month. He too decides to contribute $300 per month to a Roth IRA over a three year period, but he will invest it in stock. Over the three year period, Wild Bill contributed the same amount as Jane, $10,800, to his Roth IRA, but because the market declined, his balance was $5,800 when an emergency came up. His $5,000 withdrawal to take care of the emergency left him with a balance of just $800 compared to Jane at $5,800.
In answering this question of putting money into an emergency fund or a Roth IRA, the Roth is the better option. It offers tax and penalty free withdrawals of contributions, can be invested in cash, and preserves a major tax advantage to make retiring easier. The big caveat, however, is that if you're short on an emergency fund and retirement savings, choose cash instead of the markets. Only after your cash reserves balance has grown to a sufficient level should these funds be invested in more volatile assets.
- Investing in cash is certainly better for protecting against an emergency, but the market is usually up more often than not. Why should cash be held over a stock portfolio in these examples?
- If Jane and Wild Bill had $10,000 instead of $3,000 in their emergency fund, should they take money from their reserves and put them into a Roth IRA or leave the money where it is?
- Once Jane and Wild Bill have reached their emergency fund goal of $15,000 through the Roth IRA, is it safe to invest the entire amount in a portfolio of stocks and bonds? If not, how much should be put into the markets?