Last weekend, I had a great opportunity to speak with a group of pharmacists attending the American Pharmacists Association (APhA) New Practitioner Network “Day of NP L.I.F.E.” in Washington, DC. I love working with new practitioners since I can relate best to this group and the financial challenges they are facing when transitioning from pharmacy school to new practitioner life where a generous income can quickly evaporate due to several competing financial priorities including crushing student loan debt.
During this session at the “Day of NP LIFE” event, I had a great question come up that I thought was worth sharing with this group following the blog.
Can you use a Roth IRA to save an emergency fund?
While the technical answer is yes, I will make a case that you shouldn’t do it. Before we address why this isn’t the best idea, we need to talk further about Roth IRA’s.
In short, a Roth IRA is a tax-advantaged savings vehicle in which after tax contributions grow tax-free. Therefore, if you put in $5,500 a year (the maximum contribution amount per person) and after 30 years it grows to $1 million, that is $1 million dollars available to you without any additional taxes due since you already paid taxes on that money when you got your paycheck. Pretty awesome, right?
Compare that to a 401(k) plan where contributions aren’t taxed going in but do get taxed coming out (boo!). For example, if you have a 401(k) account that grows to $1 million and you want to withdraw funds starting at age 65, those dollars (both the initial investment plus any growth) will be taxed as ordinary income since you never paid taxes on that money to begin with. Depending on your income tax bracket, you might owe 20 cents on the dollar or more in taxes. Not cool.
Before getting too excited about the Roth IRA option (because it is pretty awesome), you need to be aware of income-limits that exist in order to be eligible to contribute to a Roth IRA. For 2016, if you are married filing jointly and your modified adjusted gross income is <$184,000 per year or you are single making <$117,000 per year, then you can contribute up to $5,500 per year (or $6,500 per year if 50 years or older). If you are married and at least one of you is earning an income, you both can contribute up to $5,500 per year (or $6,500 per year if 50 years or older). Check the IRS rules if you have any questions. If your household income prevents you from contributing to a Roth IRA, you should see if you could take advantage of a backdoor Roth IRA.
All of your contributions to a Roth IRA can be pulled out at any time tax-free (since you already paid taxes) and without an early withdrawal penalty. However, if you pull any of the growth, or interest earned, prior to age 59 ½, that would be hit with an early withdrawal penalty (with a few exceptions).
So…if you could save money for an emergency in a tax-sheltered account where contributions could grow and no taxes or penalties would be assessed if withdrawing your own contributions, why in the world would you not save an emergency fund within a Roth IRA?
There are three main reasons I would advocate against doing this:
First, well all know that anytime you invest money, there is a potential for risk and losing some, or all, of that money. An emergency fund is meant to be there when you need it and in this situation, the risk of losing money isn’t worth the potential gains. After all, the amount in your emergency fund should be a fraction of the amount you will have saved for retirement. Therefore, the emergency fund isn’t the place to be focusing on investing and growth.
Let’s look back to 2008 as an example of where this risk could have become reality if you used an investment vehicle to save for an emergency fund. When the ‘housing bubble’ popped, the Dow Jones Industrial Average (DJIA) dropped by more than 50% during an 18 month period between October 2007 and March 2009. If you had any money invested in the stock market in 2008, I’m sure you remember it well. Therefore, if you had $30,000 earmarked for an emergency fund in a Roth IRA, that could have decreased to less than $15,000 during this 18-month period.
While we would hope the occurrence of an emergency wouldn’t conveniently align itself with your investments going down the tube, you never know, and that is the inherent risk of investing. I love being aggressive in investing for retirement but not when it comes to an emergency fund. Remember, your emergency fund is intended to protect the rest of your financial plan. It is the guard in place to fight off the annoying attacks that life presents from time to time.
Second, the money in the Roth IRA may not be as readily available as you would like when an emergency hits. Depending on the company you are working with that holds your Roth IRA; you could get your money within a few days or couple weeks. Unfortunately, emergencies aren’t always very patient.
Third, if you pull the money out, there is a risk that you will not repay. “But, not me. I won’t do that.” Right…
We all like to think we are smarter than this, but we know that human behavior is the number one factor that gets in the way of a successful financial plan. Whether that is pulling out of the stock market during a down period or whether that is not refunding your emergency fund, this is a risk that must be considered.
Why do I need an emergency fund anyways?
I know, boring, right? Especially if you are trying to focus on paying off debt, saving for retirement, buying a home, paying a house off early or saving for kids college.
An emergency fund serves two main purposes.
First, it gives you peace of mind that an emergency resulting in a significant unexpected expense isn’t going to blow up and derail the rest of your financial plan. This makes life a whole lot less stressful in the moment when an emergency hits. And don’t worry; it will come.
Jess and I experienced this recently when our minivan sliding door fell off. Seriously, it fell off after my best friend snipped the cables with no other option left to get the door back in place so we could get home safely. Looking back, I’m not sure this should be categorized an ‘emergency’ expense considering the van has 170,000 miles on it, but nonetheless, it was an unexpected expense. We were grateful it ended up being an easy fix that cost less than $200. While the expense wasn’t a big hit in this situation, having the peace of mind during the ‘emergency’ knowing we were able to cover the expense and had planned for situations such as this was a great feeling. If you want to minimize the financial stress in your life and prevent money fights with your spouse, get a good emergency fund in place as soon as possible.
Second, a good emergency fund protects you from borrowing from retirement or taking on additional debt when an emergency strikes. According to the 2015 Bankrate Consumer Survey, 30 million Americans (13%) tapped into retirement savings to cover an unexpected expense (aka “emergency”). Certainly not ideal considering that in most cases, this comes with taxes and a penalty for early-withdrawal.
So, what should an emergency fund look like?
A good rule of thumb is saving up 3-6 months of expenses (not income) in a place that is readily accessible such as a simple savings account or money market savings account. Ideally, this should be separate from your day-to-day checking account to avoid the temptation of drawing from the emergency fund when you overspend your account. If it’s not there, you won’t overspend your account.
Don’t get too excited about the annual percentage yield (aka how much interest you will earn per year) on a simple savings or money market account. A quick search online at the time of this post showed savings accounts having rates hovering around 1% and money market savings accounts around 0.75-1%. If you are looking for an account, you can go to Bankrate to search for the best rates. You should also check with the bank you are already using to see if their rates are competitive. Save any excitement for returns to your retirement savings. The goal here is just security and protecting your financial plan. Look for an account that has no regular fees, low or no minimum balances and is able to get you your funds in a short period of time.
There are four questions I commonly receive about emergency funds.
Q: Which should I do? 3 months? 6 months? Somewhere in-between?
A: Two main factors that impact this decision include your money personality and your ability to get extra cash in the event of an emergency and/or losing your job. First, and most importantly, what is your personality when it comes to money? Can you sleep better at night knowing you have an extra cushion in the event of an emergency? Where applicable, make sure to take your spouse’s personality into account when making this decision. I always suggest that if one partner wants to be more conservative (6 months of savings) and the other more aggressive (only 3 months), it is best to err on the side of 6 months. The second major factor has to do with your ability to get extra cash quickly in the event of an emergency. For example, in the event of a major health crisis or a job loss, can you or your spouse pick up some extra money through working extra shifts to avoid having to borrow to cover the expense? If yes, maybe you err towards the 3-month end of savings.
Q: I don’t have anything saved up for an emergency fund. How do I practically build one up?
A: Make this a budget item to pay yourself first rather than trying to scrape up what is left afterwards. Obviously you want to build this up as fast as you possibly can but if you are several thousand dollars off, determine what that difference is and make a plan to save some each month over the next year or two to catch-up. For example, if you determine that you need $15,000 in your emergency fund and have only $1,000 saved to date, take the difference and divide it by 24 to achieve this goal in two years. The result would be saving $583 per month for 24 months to have a fully funded emergency fund.
Q: How should I handle an emergency fund as a student or resident?
A: If you are a student or resident with limited income and don’t have any money saved up for an emergency, get a small fund started (e.g., $500-$1,000) to avoid having to take on any additional debt in the event of an emergency. Then, once you have finished school and/or residency, re-evaluate in the context of the question below. Make a commitment to have this ‘starter’ emergency fund built up within the next 3 months.
Q: How do I balance the importance of having an emergency fund versus paying off high interest rate debt?
A: If you have a plan in place to pay off your debt in a short period of time (e.g., 12-18 months), I think you can get away with a small emergency fund (e.g., 1 month of expenses) with the commitment that you will build that up further after you have your debt paid off. If you are going to be paying off debt for much longer than 12-18 months, I recommend you build up a full emergency fund while paying minimum on all debt payments. Then, after that emergency fund is built up, go ahead and move forward with paying extra on your debt to minimize the amount of interest you will pay on that loan over time.
Your Financial Homework: Get an emergency fund in place if you don’t already have one. If that can’t practically be fully funded in the next couple months, make this a part of your monthly budget. Like budgeting, building an emergency fund isn’t ‘fun’ but I promise, it will pay off. What are you waiting for?