The Tax-Exempt Emergency Fund

emergency fund 2Everybody should have an emergency fund because, well, emergencies happen. You don’t have to tell that to the thousands of people who lost their jobs during the Great Recession, who suddenly had to pay their bills out of savings rather than a monthly paycheck.  Cars break down, roofs and air conditioners need fixing, and there are probably a million other examples where you need money unexpectedly.

There’s an interesting debate among financial services professionals about how much money should be in that emergency fund.  A rough consensus before the Great Recession was that everybody should have at least six months of living expenses in a cash account that is not exposed to the vagaries of the stock market.  But so many people have been out of work for longer than six months, that there is a tendency now to recommend larger cash cushions.

At the same time, however, the cost of putting money on the sidelines has gone up in recent years.  When money markets and short-term bonds were yielding 4%, putting a chunk of your portfolio into these sectors was far less painful than it is today.  Many financial advisors are loath to recommend that you keep that much of your money in accounts that basically promise to give you your money back and nothing more.  Professional advisors call this an “opportunity cost”–the difference between what you might earn in the stock market versus the fractions of pennies that money market funds are tossing their investors these days.  The push and tug means that everybody is recommending a different amount of money to hold in reserve these days–and looking for a way out of the need-for-cash-in-a-zero-rate-environment dilemma.

One possible alternative making the rounds is setting up a Roth IRA and letting that gradually become your emergency fund.  You can withdraw your contributions to a Roth back out again tax-free at any time, and the money can be invested in assets that actually generate a return without you having to pay any taxes on those gains.

There are several ways to do this.  In 2013, you can make a $5,500 contribution to a Roth IRA, and unlike a traditional IRA, you will not get a tax deduction for the contribution.  But also unlike a traditional IRA, you can withdraw that money back out again before you reach age 59 1/2.  If you’re over age 50, then you can make a $6,500 contribution.  Unless you’re living in a cave and foraging for your meals, that probably doesn’t equal six months of living expenses, but it does free up an equal amount from your cash account that can now be put to work in the markets.  Gradually, a few years down the road, the Roth IRA account grows large enough that it can take over as your emergency fund.

Another possibility is to transfer some of your traditional IRA over to a Roth IRA–what is called a “partial rollover” among professional advisors.  You have to pay taxes on the money that is rolled into the Roth, so this has to be handled carefully–there are conditions where you might pay more in taxes on the rollover than you would save in the long run.  But in a year when you will be in a lower tax bracket, you might fill up that tax bracket by making a small partial rollover without triggering any higher taxes on your earnings, and over the years, this could raise the value of your Roth IRA to the point where it can be an effective emergency fund.

There are, of course, a few problems with this approach.  First, if the Roth account is invested in the stock market, and the stock market goes down, so too will the value of your “emergency fund.”  Over the long term, markets tend to go up, so this eliminates your opportunity cost, but if the markets drop, you should probably make up the difference in a side cash account, to be on the safe side.

A bigger issue is the pain your advisor will feel when you take money out of a permanently tax-deferred account to pay living expenses.  Money in a Roth IRA is precious to anyone’s future; it represents assets that have been removed from the tax system, and can be passed on to heirs tax-free.  If you have to dig into your Roth because you lost your job, a sensitive advisor might shed actual tears at the lost tax benefits.

Using a Roth IRA as an emergency fund is not a perfect solution to today’s market, because today’s market is so far from perfect.  But, for younger people who cannot afford to maximize all their retirement plans and additionally build an emergency fund,  it’s a solution you might consider.


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