Tax-advantaged retirement accounts such as 401(k) plans and IRAs are crucial tools as you invest for your future.
If you’ve made it a priority to meet your annual contribution limits for a retirement account, but your income is tight one year, what do you do? Should you go as far as to tap into your emergency fund to put money into a retirement account?
That’s what a listener of the Clark Howard Podcast recently asked.
Should I Use My Emergency Fund To Max Out My IRA Contributions This Year?
Should I use the money in my rainy day fund to contribute the maximum amount to my IRA this year?
That’s what a Clark listener wondered on the March 30 podcast episode.
Asked Sara in Colorado: “We always max out our Roth IRA, but this year our income is a little tight. We have $60,000 in our emergency fund. Should I use money from the emergency fund to max out our Roth IRA? Even though it will take a long time to pay the emergency fund back?”
Clark’s long-standing opinion is that you should strive to build an emergency fund with enough money for three to six months of your household expenses.
In other words, if your household spends $10,000 a month, then an emergency fund with $30,000 would be equal to three months of expenses.
In this case, we don’t know Sara’s monthly expenses or overall financial circumstances beyond the emergency fund.
“If that $60,000 buys you six months of living expenses, I would be comfortable with you reducing that cushion down to a smaller number by moving money into the Roth to fully fund [your IRA],” Clark says.
“If that $60,000 covers, let’s say, three months of living expenses or less, not knowing what your financial situation is, I would keep the money in the emergency fund and not fully fund the Roth this year.”
You Can Withdraw IRA Contributions Tax-Free
With a Roth IRA, you can withdraw the funds you contributed at any time tax-free. You may not withdraw any profits you’ve made from investing for free any time you want.
So in this case, Sara could contribute the funds to her Roth IRA. And then if a financial emergency occurred, she could withdraw her contributions — not the earnings on those contributions — to pay for the emergency.
However, withdrawing your contributions equates to an enormous opportunity cost. Any money you pull out will not remain invested and will not continue to grow in value over the years.
Clark, a huge fan of Roth IRAs, says that once you start pulling your contributions out of your IRA, you may form a bad habit.
“I’m always nervous that the Roth IRA becomes like a piggybank,” Clark says.
“That’s why I’m using months of living costs as the threshold. The more [your emergency fund is past] three months of living expenses, the more comfortable I am with your pulling money from that rainy day account to fund your Roth.”
It’s a great idea to fully fund your Roth IRA every year if you can. It’s one of the best tools to save and accumulate money for your retirement.
However, you don’t want to put yourself in a position to pay for any unexpected financial cost via a high-interest credit card.
If you’ve fully funded an emergency fund, which Clark says equates to six months of your living expenses, it’s OK to tap your emergency fund to reach your IRA contribution limit.
Once you get to three months of expenses or less in your emergency fund, you may need to skip fully funding your IRA for the year.