Roth IRA as an Emergency Fund? (Withdrawal Rules)

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 an economic crisis. 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.

Quick Recap: Roth IRA Rules

A Roth IRA is an account that allows qualified distributions on a tax-free basis as long as certain conditions are met. Although Roth IRAs are similar to traditional IRAs, their tax treatment by the Internal Revenue Service (IRS) is quite different.

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 paid income taxes and received no tax deduction when you made the deposits. But with a traditional IRA, you pay income taxes on withdrawals in retirement.

Roth IRAs are not mandated to take required minimum distributions (RMDs). RMDs are a minimum amount, which is established by the IRS, that must be withdrawn from your traditional and defined-contribution IRAs each year while in retirement. RMDs must begin after age 72. While RMDs were suspended for 2020 as part of the coronavirus stimulus bill, they are back for 2021 and beyond.

Roth IRA Contribution Limits

A Roth IRA allows you to contribute $6,000 per year in 2021 and 2022. If you’re married, you and your spouse can each contribute $6,000 for a total of $12,000. Each individual is allowed to contribute an additional $1,000—called a catch-up contribution—if aged 50 or older.

Roth IRA Income Limits

There are limitations on how much you can earn to qualify for a Roth.

The income limits are adjusted each year by the IRS. These are the limits for the 2021 and 2022 tax years based on your income and tax filing status:

• For the 2021 tax year, if you’re married and file a joint tax return, the phaseout begins at a modified adjusted gross income (MAGI) of $198,000. If you make more than $208,000, you aren’t eligible for a Roth. Single filers hit the threshold at $125,000 and are disqualified if their incomes exceed $140,000.
• For the 2022 tax year, if you’re married and file a joint tax return, the phaseout begins at a MAGI of $204,000. If you make more than $214,000, you aren’t eligible for a Roth. Single filers hit the threshold at $129,000 and are disqualified if their incomes exceed $144,000.

Roth IRA Withdrawals

You often hear that “Roth IRA withdrawals are tax-free!” And although that’s true, it is complicated. Not all withdrawals are created equal in the eyes of the IRS.

When filing your tax returns, you don’t include in your gross (taxable) income any distributions that are a return of your regular contributions from your Roth IRA(s). Because contributions to a Roth are made with funds on which you’ve already paid taxes, IRS rules allow you to withdraw that money (or strictly speaking, the same amount of money) without owing any more tax on it.

But any sums that accrued in the account—anything above and beyond what you originally deposited—are a different story. You have to wait until after the five-year period beginning with the first tax year for which a contribution was made to the Roth IRA in order to begin making withdrawals. If you don’t wait, they are subject to taxes and a penalty if you’re under age 59½, and to income taxes, if you’re older.

In other words, the contributions can be withdrawn at any time without penalty or taxes. However, investment earnings generated from your deposits—interest income, dividends, capital gains—must remain in the account for at least five years, and ideally until you’re at least 59½ to avoid incurring a 10% penalty and taxes.

The good news is, Roth withdrawals are made on a FIFO basis (first in, first out)—so any withdrawals are initially classified as coming from contributions. Earnings aren’t considered touched until a sum equal to all the contributions you’ve made has been reached.

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. However, accessing these funds should be your last resort.

Matt Becker, a fee-only certified financial planner (CFP) who runs the site Mom and Dad Money, 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. However, for some, withdrawing Roth contributions might be 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. In other words, don’t start dipping into investment earnings. It’s important to note that IRA funds aren’t labeled “contributions” and “earnings” on your statement. Still, following this rule is simple: Don’t withdraw more than you deposit.

“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—meaning cash or something that can easily be converted to cash—that still earns a bit of interest, but one from which you can withdraw at a moment’s notice without losing principal.

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.

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 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.

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 a rollover contribution.

How to Withdraw Roth Funds

The availability of funds 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 you make 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 take funds out of a money market or mutual fund and you put in your withdrawal request before 4 p.m. EST, you may have the money by the next business day.

If the money is invested in stocks, you will typically need to wait three business days, 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 from $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 funds 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 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. But 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.

But 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.

Redeposited Roth Funds Scenarios

Let’s look at some examples for clarity. Check with a tax expert to be sure these apply to you and if there are any exceptions or changes to the rules.

Example 1

You’ve got $30,000 in a Roth IRA. You’ve contributed $20,000 in prior tax years and $6,000 in 2020. The remaining $4,000 has come from investment growth (earnings). If you withdraw $6,000 worth of contributions from 2021, you have until April 2022 to re-contribute those funds back into the Roth IRA.

By withdrawing your contributions from 2021, 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, 2022, and haven’t contributed $6,000 back into the Roth IRA, then you won’t get to make a 2021 contribution at all.

Example 2

Same situation: $30,000 in the Roth, $20,000 from the prior year’s contributions, $6,000 contributed in 2021, and $4,000 in growth. You withdraw $2,000 of contributions. You have until April 2022 to contribute another $2,000, or your Roth IRA contribution for 2021 will only be $4,000.

Example 3

Same situation, but this time you withdraw $10,000. That means you’ve taken out your $6,000 in contributions from 2021, as well as $4,000 from the past. You cannot re-contribute the full $10,000 in 2021. 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 year, plus $2,000 more to bring it up to the $6,000 annual contribution limit for that year. In other words, you wouldn’t be able to add another $6,000 for the year since you had re-contributed the $4,000 that you withdrew in the prior year.

To effectively borrow from your Roth IRA, you would need to have already contributed earlier in that 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.

The Bottom Line

Since a Roth account is one of the most flexible retirement accounts available, it can double as an emergency fund. It can give you the safety of knowing that, if you need it, you have penalty-free access to any of the contributions that you made to the account over the years. And if you wait long enough, you’ll get penalty- and tax-free access to the account’s earnings as well.

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