This post happened thanks to my friend Bryant! He asked me for my thoughts on whether he should contribute more to his Roth IRA or to fatten up his emergency fund. This post can apply to those who don’t have their Roth IRA maxed out. This includes regular Roth contributions of $6,000 a year in 2019, as well as backdoor and Mega Backdoor Roth limits. I learned about the Mega Backdoor Roth earlier this week and was very wowed!
One of the first things anyone should work towards is building up an emergency fund. This is exactly what it sounds like, a fund for emergencies. The prevalent advice is to have 3 to 12 months worth of expenses. Choosing how large of an emergency fund depends on your lifestyle and job. If you have a stable job and income, and live in an apartment and walk to work (very little chance of home or car maintenance costs!), then you will most likely feel safe with a smaller emergency fund. And of course, if you are on the opposite end of the spectrum, you would most likely want to establish a larger emergency fund. This fund should not be used except for EMERGENCIES. You want to have a budget for all your other expenses.
A common place to put your emergency fund is in a checking and savings account. There are savings accounts with online banks that have much higher interest rates than savings accoonts at brick and mortar banks. One example is Ally Bank. Their current savings account interest is 2.2% APY as of February 2019. Compare that to Bank of America with their reward savings account of 0.03% to 0.06% depending on how much money you have with them.
However, if you still have room in your Roth IRA for more contributions, it may make sense to instead put part of your emergency fund in there instead. This would work for these 3 reasons and requirements:
- In a Roth IRA, you can withdraw your after-tax contributions anytime.
- The Roth IRA has safe and liquid accounts that earn some interest (savings account, money market account)
- You understand all the other requirements that comes with a Roth IRA
First, a Roth IRA lets you withdraw your contributions without penalty anytime. This means as long as you know how long it takes to transfer funds out, which may be a a few business days, then this could be a good place to hold some funds.
Second, since you may need this money for emergencies, don’t invest it! Put it in a IRA savings account or CD, such as the one at Ally Bank. As of 2019 January, their IRA savings offers 2.2% interest. If you think you are less likely to need your emergency fund, then you can also use their 12-month CD which offers 2.75% right now. You can still withdraw if you need the funds, with a 60-day interest penalty.
Third, understand all the requirements that come with a Roth IRA. A few important ones are that you don’t want to accidentally withdraw earnings or rollovers and incur penalties. Also, in the case that you withdraw money, you will need to fill out more paperwork come tax time. Lastly, since there is a limit for contributions, it will be more difficult to contribute more money if you do withdraw funds.
What benefits do you get for this?
Why would you want to do this? Since there is a limit every year, you wouldn’t be able to go back a year to contribute more. Therefore, if you contribute now and end up not using the money, then you would have more stashed away in your Roth IRA.
The second benefit is that your earnings are not taxed. A 2.2% interest inside an IRA means you keep the full 2.2% interest. A 2.2% interest outside of an IRA could mean you get taxed upwards of 30%+, with your marginal federal tax rate and state taxes. That would result in only 1.54% left after taxes!
Read more about benefits of a Roth IRA for retirement savings here: