When people finally start deciding to save money, one of the more common questions is: “Do I need to build emergency reserves in addition to saving for retirement?
How to roll retirement savings and rainy day money into one account
The thing about saving money is that you really need to save on two tracks — one for retirement and another for a rainy day.
Rainy day money, as we all know, is earmarked for any emergencies that are lurking right around the corner. But here’s the thing: While it’s been said that into every life a little rain must fall, the reality is that not everybody faces a financial deluge.
So that’s why the smart move is to save rainy day money (for potentially short term use) in a vehicle where it can double as retirement money (for the long haul) if you don’t need to access it.
That’s where a Roth IRA comes in.
Understanding the Roth IRA
A Roth IRA allows you to invest money that’s already been taxed in your life, like the money you get in your take-home pay at the end of each pay period.
Here’s the beautiful thing about a Roth IRA: Because the money going into it has already been taxed once, it won’t get taxed again when you need to take it out in retirement.
That’s different than a 401(k), where you fund the account with pre-tax dollars that come out of your paycheck before you even see them — basically a tax break today in exchange for deferring taxes until further on down the road.
With a Roth IRA, you can save up to $5,500 per year, or up to $6,500 if you’re age 50 or older.
Any earnings that build up from investments in your Roth IRA must remain in the account until you’re at least 59-and-a-half before you can withdraw them.
Earnings are the money paid by dividends or the appreciation in the stock price of the underlying equity investments within your Roth IRA.
Now here’s the most relevant feature of a Roth IRA for this discussion: A Roth IRA allows you to pull out all your contributions tax-free and penalty-free whenever you need them. There are no artificial timelines or milestone birthday requirements!
Contributions refers to the up to $5,500 or $6,500 — depending on your age — that you used to open the Roth IRA account.
That goes to the heart of why a Roth IRA can essentially function like a rainy day savings account. The money (the contributions) is there if you need it in an emergency.
But if you don’t, both contributions and earnings just sit there growing tax-free — since you already paid taxes on the money you deposited in the first place — and that can really help fatten your retirement nest egg.
Keep in mind that saving in a Roth IRA should ideally be done in addition to whatever you’re saving in a 401(k) at work or an individual retirement account (IRA) you set up on your own. If your work has a match on your 401(k), be sure you’re contributing enough to pick up the full match before moving on to do a Roth IRA.
Finally, speaking of starting a Roth IRA, beware of making the #1 mistake people make when opening an investment account!