Using A Roth IRA as Your Emergency Fund

IRA withdrawal penalties can be as high as 10% if you use your Roth IRA to fund your emergency account. There are exceptions to these tax penalties though.

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Using A Roth IRA as an Emergency Fund

Powerpoint slides on a superior retirement planning strategy called Roth IRA on Roids which allows for tax-free distributions, tax-free growth, guaranteed principal and guarateed death benefits.Joseph Kelly of the Upper East Side has a Roth IRA account. While he is aware of how the retirement account works and the rules associated with it, he was not aware that it could be used as an emergency fund. He, like many other people, only uses their IRA as a form of retirement savings. While this is the most common avenue, there are other ways to use that money in the account. Joseph has recently learned that he can use a Roth IRA as his emergency fund if necessary. However, there may be penalties involved if he does not meet certain requirements and abide by the IRA withdrawal rules.

Using a Roth IRA as your emergency fund: When Is It Safe?

Ideally, if you are over the age of 59 1/2 and you have been contributing to your Roth IRA for more than five years; there is no reason why this account cannot be used as an emergency fund. In simple terms, a Roth IRA can be used as an emergency fund if you are over the age of 59 1/2 and you will not have to pay any IRA penalties or any taxes at all. In Joseph's case, he is over the age of 59 1/2, so it is simply a matter of withdrawing from the account. As long as Joseph makes sure he has met the withdrawal requirements for your Roth IRA, there will be no penalties or taxes involved should he decide to remove the money and use the Roth IRA as an emergency fund.

This is one of the wonderful benefits of a Roth IRA. As long as Joseph has met the age requirements and you have had the account for five or more years, he can use a Roth IRA as his emergency fund or for any other reasons he wishes. Most people try to avoid withdrawing from the account if possible because it will no long be able to grow tax-free and will deplete the overall retirement savings account. Yet, in the time of a crisis or an emergency, the Roth IRA is a perfect source for tax-free money.

Using a Roth IRA as your emergency fund If Under 59 1/2 Years Old

Now that we have discussed the option of using a Roth IRA as your emergency fund if you are over 59 1/2, let's discuss what would happen if you were under that cutoff age. For example, let's say Joseph is only 43 years old. If he attempts to withdraw more than he has contributed to the account, he will likely face IRA penalties. For example, if Joseph has only contributed $3,000 this year to the account, he will be allowed to withdraw up to that amount. However, if he has to withdraw more than he has contributed, he will then be taking out some of the earnings. This part of the withdrawal amount will be taxed.

No matter what your situation is, if you are not 59 1/2 when you withdraw from the account, you will likely incur an early withdrawal penalty when withdrawing the earnings. This amount is 10% of the amount withdrawn. So, if Joseph has only contributed $3,000, but makes an additional $1,000 because of a wise investment decision, then withdraws $4,000, he will be taxed on that additional amount because it did not come from his contributions. That could add up to some serious money, depending on what his financial needs are at the time. If this is the situation Joseph is in, it may not be beneficial to use the IRA retirement account as an emergency fund. Regardless of what the current situation is, any withdrawal before 59 1/2 that consists of withdrawing earnings in the account will be considered an early withdrawal. If Joseph has other available funds that do not have penalties attached, he should consider tapping into those resources before withdrawing from his Roth IRA account.

Roth IRA emergency fund: Exceptions to 10% Early Withdrawal Penalties

Of course, there are some exceptions to these rules. When using your Roth IRA as an emergency fund, you will be subject to the 10% early withdrawal penalty, but there are some situations where this penalty will not be applicable. As with most rules, there are exceptions. For instance, if Joseph were to use the money from his Roth IRA as a down payment on a house, he would not be penalized. This is only the case if the withdrawn amount is less than $10,000 and is being used for a first time home purchase. Another situation is if Joseph were to become disabled. If this happened, he would not incur the 10% penalty for withdrawing from the Roth IRA account.

There are also other cases where the penalty would not be applied. If Joseph incurred medical bills, he could withdraw from his Roth IRA to pay these expenses. The only rule when doing this is that the expenses to be paid must be more than 7.5% of his adjusted gross income. In addition, the Roth IRA account can be used to pay health care insurance premiums if Joseph were to become unemployed. Any of these mentioned situations will be considered emergencies, so the Roth IRA account could be used as an emergency fund without incurring the 10% early withdrawal penalty.

These are not the only ways to avoid paying the penalty. There is one other way. In Joseph's case, he is allowed to take a series of "substantially equal periodic payments" from his Roth IRA account. These payments are based on his life expectancy and last for at least 5 years or until Joseph reaches the age of 59 1/2, whichever time frame is longer.

72(t) Distribution – Split IRA to Receive Distributions

Aside from these methods of using your Roth IRA as an emergency fund, account owners also have the ability to split part of the IRA, taking distributions from that account. By doing so, the owner will reduce the amount of money that can be accessed in the account each year. This will, in turn, protect the remainder of the nest egg. This process is known as a 72(t) distribution. This particular strategy is very beneficial to those individuals who are in their fifties and are able to commit to receiving distributions for at least 5 years. However, if this option is chosen, the account owner is stuck with it. If changes are made, there will be severe penalties which require the account owner to pay the 10% retroactively, back to the first withdrawal, as well as interest.

Even though there are many rules and exceptions to using a Roth IRA as an emergency fund, many people choose to do so. This is why it is so important to contribute as much as you possibly can to the IRA account each year. It will provide you access to more money should you ever decide to use the account as an emergency fund.

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Rocco Beatrice, CPA, MST (Master of Science in Taxation), MBA (Master of Business Administration), BSBA (Management/Accounting), CWPP (Certified Wealth Preservation Planner), CMMB (Certified Mortgage Broker), CAPP (Certified Asset Protection Planner), Managing Director, Estate Street Partners, LLC. Mr. Beatrice is an asset protection, award-winning trust, estate planning and tax expert.

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