Can you use your retirement account as your emergency fund?

Photo courtesy of Hernán Piñera


My high school algebra teacher always had some sagacious advice for our class. “Open the door before you walk through it.” That sort of thing. This always elicited a laugh from us, which I suppose was the point.

Though laughs aside, there is an order to operations. Walk before you run. Shallow before deep water.

And yet, it can be tempting to want to combine steps, for efficiency reasons. After all, no one says “I wish I could be less efficient.

Which brings me to today’s topic.

I’ve talked a lot about the emergency fund. For me, it was the game changer, the point at which I found a durable and visceral sense of relief, even stronger than getting out of debt.

And yet, a common response to the relatively high numbers I cite for how much you need to have in an emergency fund is one of internal conflict: “But I need to start saving for retirement now!

I understand the sense of frustration. If this stuff was easy, then everyone would be set for life, and we wouldn’t read articles like this.

But I want for you to channel the despondency into action. Yes it’s hard. But you can do this.

Step combining

Putting money into an emergency fund does in fact keep you from putting money away for retirement. What if there was a way to combine them?

And in fact there is. One could theoretically put all of one’s money into a retirement account, bypassing the more liquid savings account of an emergency fund. And when an emergency strikes, you could always take money out of retirement. And in the meantime, your “emergency fund” can grow with the market.

It sounds like a good deal. But is it?

Making some money

Let’s be clear: when you put money into a liquid emergency fund, it’s not going to increase in value. Actually, after accounting for inflation, it’s going to decrease in value. This alone would be an argument for putting your emergency fund in a retirement account (or other investment account).

But it’s not a very compelling argument. If we could find a guaranteed return on investment, I’d be more interested. But as you may have noticed, the markets are anything but stable, and if you happen to have an emergency in the middle of a crash, you may not have the cushion you need.

If that were the only reason why this is a bad plan, that would be enough. But it gets much worse.

Taking money out of a Traditional IRA

If you’re investing for retirement, the two most common options are the Traditional IRA and Roth IRA. Let’s start with the Traditional one first. (Similar rules apply to a 401(k) too.)

If you’re under 59 1/2 years of age, any money that you take out of your Traditional IRA gets subject to a 10% penalty. And then, after that, you have to pay income tax on it.

So let’s say that you make (or recently made) $50,000 a year, and you decide to take out $10,000. A 10% haircut means you’d have $9,000, and in a 25% tax bracket, you’d have $2,250 eaten off as well, leaving you with $6,750, a mere penalty of 32%.

How long would it take you to make enough in returns to offset this hatchet job? And remember that this is not an investment that will go back up again. If you take it out, it’s gone.

(There are some exceptions to these rules, but none of them are overly compelling to me.)

Taking money out of a Roth IRA

The Roth is awesome (though not necessarily for the reasons that most people think). One of the benefits about the Roth is that any money you put in can be taken out without any penalty. (This doesn’t include earnings, which have different rules.)

If you contribute $10,000 to a Roth, you can take out that $10,000. And since the Roth is a post-tax account, you pay no taxes or penalties on that $10,000.

So, at first blush, this seems like a great idea. Emergency fund here we come?

But wait: a Roth IRA has contribution limits. Unlike an emergency fund, which you can just re-fund when you’re able to, you can’t “catch up” on a Roth after you’ve taken money out. Once it’s gone, it’s gone. No backsies.

For most people, the maximum contribution per year in a Roth IRA at the time of writing is $5,500. If you invest $5,500 and let it sit for 30 years, you could have somewhere between $20,000 and $80,000! That’s a lot to lose.

So yes, while taking contributions out of a Roth IRA gets around taxes and penalties, it could cost you a bundle over the long term. I wouldn’t do this either.

Taking a loan against your retirement account

No. Seriously, just no.

Your lame fund

The emergency fund is lame. I get it. My emergency fund netted me a grand total of $76 dollars last year. Woo.

But when you put your emergency fund in a savings account, it is reliable. It is guaranteed. Which is what you want in an emergency.

Debt, then emergency fund, then retirement fund. Take care of yesterday, then take care of today, then take care of tomorrow. The sooner you open the door, the sooner you can walk through it.

Have more questions about how to make it work? Contact me and let me know how I can assist.

Mike Pumphrey

Mike Pumphrey

I'm the founder and author of Unlikely Radical, a site to help people succeed with money, achieve their goals, and live intentionally.

I offer a free phone consultation to anyone who is interested in changing their financial narrative. Are you ready? Click here for details.
Mike Pumphrey
Posted on March 14, 2016