ROTH IRAs: The Best Emergency Fund

One pillar of the Financial Independence mindset is the Emergency Fund. I agree with the principal of having an Emergency Fund, but I have a special way of creating an Emergency Fund within my financial plan. I came up with my process for an Emergency Fund by trying to maintain the benefits while removing the drawbacks of a typical Emergency Fund. Before we get into my Emergency Fund method let’s review the basics of an Emergency Fund.


An Emergency Fund is an account for funds set aside in case of the event of an unexpected significant financial need, such as the loss of a job, a chronic and/or debilitating illness or a major repair to your home or vehicle. The purpose of the fund is to provide financial security by creating a safety net of funds that can be used to meet emergency expenses. The general recommendation is that an Emergency Fund should be able to cover 3 to 6 months of living expenses. Traditionally an Emergency Fund would be a completely separate account which holds only liquid assets (cash) used solely for emergencies.


The virtues of such a fund have been championed by Dave Ramsey, Suzie Orman and the like. The main reason that these gurus advocate for an Emergency Fund is to protect individuals from unexpected expenses. Early in a personal FI journey the biggest source of disagreement is when Emergency Funds should be funded. Is it before or after other needs like paying off debt, retirement investing or saving for a house?

Some would argue that Emergency Funds should always take precedent and be completely funded before attacking any other financial goals. Others would say that having assets earning virtually 0% interest in an Emergency Fund makes no sense if you have high interest debt like credit cards or student loans. This debate comes down to the tradeoff between risk mitigation (fund Emergency Fund 1st) and best return (pay off high interest debt 1st).


When I started my career in 2009 I was familiar with Emergency Funds. Having witnessed the financial hardship that many endured during the financial meltdown I fully appreciated the need to have an Emergency Fund. However, I had no idea how I was going to fund one. I had moved to a new city to start my first job and had all of the monthly expenses that go along with an apartment. I also had $70,000 in student loans which consumed a few hundred dollars a month as well. Additionally by late 2009 the stock market looked to finally be recovering and it appeared to be a good time to invest. I was making a decent wage, but I knew I could not support all of these competing priorities at the same time.


Before I started my career I had a small amount of savings (<$3,000) in a Roth IRA. I had created this account under the tutelage of my father who is a big advocate of paying yourself first. At the time I only knew that a Roth IRA was a retirement account and funding my retirement was important because pensions were becoming extinct. I had no idea about the tax treatment or when I could withdraw money. However, with all of these new financial needs I needed to decide if it made sense to continue to contribute to it.


When I started researching my Roth IRA in more depth I was amazed at its versatility. It offered tax advantages as any investment returns would not be taxed when withdrawn during retirement. It also offered instant access to my contributions. Since the contributions are made with after tax money, these funds can be taken out at any time without penalty. There are also several instances where you can withdraw earnings without penalty before retirement (younger than 59.5 in age). These include:

⦁ You use the withdrawal (up to a $10,000 lifetime maximum) to pay for a first-time home purchase.
⦁ Using the withdrawal to pay for qualified education expenses.
⦁ If you become disabled or pass away.
⦁ You use the withdrawal to pay for unreimbursed medical expenses or health insurance if you’re unemployed.


As you can see most of these situations would fall into the “Emergencies” category. When I saw this list I had a light bulb moment. I wondered, “If the Roth IRA can be used for these emergencies then why couldn’t it replace a standalone Emergency Fund entirely”. To investigate this I listed out all of the attribute that I needed in an Emergency Fund. This list included:

⦁ Quick Availability to Funds
⦁ Low Risk
⦁ Separate from Main Savings/Checking

When I reviewed this list I found that my Roth IRA checked all of these boxes:

⦁ I could withdraw funds from my Roth IRA at any time and the removal process only takes a couple of days
⦁ I could invest in low risk money market funds with very low expense ratios
⦁ The fund was separate from my main Savings/Checking account


It also offered many other perks:

⦁ Although the funds are available they are less accessible than a savings account and therefore less tempting
⦁ Tax advantaged compounding investment returns
⦁ Also serves as a retirement account

⦁ Not included in FAFSA calculations
⦁ No required distributions
⦁ Nondeductible contributions for high earners


Based on these findings I decided to forgo a standalone Emergency Fund and instead to continue funding my Roth IRA. In order to manage risk and allow for investment returns I utilized a barbell strategy.

I split all of my contributions 50/50 between a Money Market fund and a Total Stock Market fund. This offered minimum risk on half of my money and significant upside for the other half. I continue with this asset allocation until I was able to get the low risk portion large enough to cover 3 months of living expenses. This took me roughly 8 years to achieve. Now I treat all of my contributions as strictly retirement savings and invest them based on my retirement timeline.


Those interested in this strategy who already have a Roth IRA can implement this method immediately. All this would take is a review of your existing accounts and adapting their existing investments to meet this new purpose. For those who do not have a Roth IRA, I would recommend visiting Vanguard to get more information. I use Vanguard for my IRAs because they offer the best combination of low cost investment options.

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