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With the economy in a roller-coaster ride, it’s time to talk about killing two birds with one stone. Even in times of trouble, you have to keep an eye on the long-term, and the Roth IRA has a very nice capability that most people don’t know about.
How is a Roth IRA Different than Traditional IRAs
First, a bit about the Roth. It was first established in 1998 by Senator William Roth of Delaware. It’s similar to a traditional IRA (limited to $5000 in 2008, or $6000 if over age 50) and withdrawals are tax free, if the account is over 5 years old and the recipient is at least 59 1/2.
The difference is that the Roths are a tax free vehicle. That means you pay the taxes now, and they GROW tax free from then on. This is the opposite of the IRAs, which pay the Taxman at the other end.
The Roth as Emergency Fund
The best trick is because of this ‘pay now’ feature. If you diligently put away money in the Roth, and something happens that you need that money, YOU CAN WITHDRAW IT WITHOUT PENALTY!. (Note: Only the contributed amount, any interest earned will be taxed).
You can contribute the max each year, upping your emergency fund supplies AND save for retirement at the same time. There’s no time like the present to start!.
Catches, Gotchas, and Other Notes
There are a couple of things to keep in mind.
Contribution limits - You can only contribute to a Roth IRA if you fall within these limits
- Single filers: Up to $99,000 (to qualify for a full contribution); $99,000-$114,000 (to be eligible for a partial contribution)
- Joint filers: Up to $156,000 (to qualify for a full contribution); $156,000-$166,000 (to be eligible for a partial contribution)
- Married filing separately (if the couple lived together for any part of the year): $0 (to qualify for a full contribution); $0-$10,000 (to be eligible for a partial contribution).
Moving from a Traditional to Roth IRA - You are allowed to move your existing Traditional IRA to a Roth IRA, but you must a) have a Modified Adjusted Gross Income of less than $100,000, or 2) you need to wait until 2010 when the restriction is removed.
When you do the move you’ll also have to pay the taxes on the money rolled over, so if it’s a significant amount, you can either roll it over in whole (and save up enough to cover taxes) or break it up over a few years to spread the tax burden.
Safety Net Belt and Suspenders
It’s not hard to open a Roth IRA. Most banks or credit unions offer them, and it’s as simple as opening a checking account. You also have a wide range of investments typically, so you can invest in a style that makes you comfortable. Risk averse can go for more conservative investments (bonds, blue-chip stocks, etc) and those risk tolerant daredevils can go for the aggressive ones (growth and income stocks). Either way, you start saving for retirement AND establish your fall-back money in a safe place earning you some interest.
Where are you putting YOUR emergency fund money? Leave us a comment and let us know!
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May 27th, 2008 at 8:48 am
This is an interesting idea, but how accessible would the money be in a roth ira? If you had an emergency could you pull the money out within a day or two? If you could this might not be a bad idea, i just would like to make sure that the assets are available if I need them.
May 27th, 2008 at 9:03 am
@Pete, My IRA is connected to my bank account, so it only takes 1 business day to transfer the money to a ‘real’ accessable account.
You can set it up that way, or realize it’ll take a few more days (if you’re comfortable with that) with separated accounts. Hopefully the emergency isn’t so immediate that you need cash that same day.
May 27th, 2008 at 3:17 pm
I use Vanguard as my Roth IRA holder. I have it invested in a very diversified low cost index funds.
50% in the Vanguard Balanced Index Fund Investor Shares (VBINX) which holds 80% stocks and 20% bond and 50% in the Vanguard Emerging Markets Stock Index Fund Investor Shares (VEIEX) which holds the rest of the world.
Since I file my taxes jointly and my wife is a housewife, I plan on investing her share of a Roth IRA in stocks that I know will do well. The advantage of using my Roth IRA for trading shares is that I will not pay any taxes on any gains even if I sell my shares the next day! Its tax free!
May 27th, 2008 at 11:38 pm
Good article as usual. I was reading Prad’s comments, and realized how convenient a diversified bunch of index funds would be for my Roth IRA.
I could literally put my funds on autopilot, and spend more time managing my traditional investment accounts.
Plus I read John Bogle’s Book “Common Sense Investing,” and I’ve been meaning to open an IRA account for quite some time.
Most likely, I will set up some time of SEP IRA with Vanguard. Thanks for the article, and the quality comments that came it with
June 1st, 2008 at 4:06 pm
Randall - I have often wondered if you could use a Roth as an emergency fund! I have one question though - let’s say for 2008 I contribute the max of $5,000. Before 2008 is up, I take out $3,000 for an ‘emergency.’ Can I then put the $3,000 back in before 2008 is up? I mean, my net contribution would still be $5,000 in the end. Does that make sense? I’ve been dying to get the answer to this and can’t find it anyplace. Thanks!
Shawnas last blog post..Free movie screenings
June 5th, 2008 at 5:08 am
@Shawna, As for deposits, it’s not like a bank deposit. Daily balance doesn’t count, only how much you put in. If you take some out during the year, you’re STILL limited to $5000 deposit (this year). You wouldn’t be able to take out a few thousand and ‘put it back’. In your example, your TOTAL deposit for 2008 would be $8000, which would be beyond what you’re allowed to put in. That’s why it needs to be a TRUE emergency.