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Tuesday, April 26, 2011

Retirement vs. Emergency Fund

If you do not have a full (whatever that means according to you) emergency fund saved up, you might want to dedicate all of your funds towards the emergency fund and not save anything for retirement. However, I think there is another option that most people do not realize. Your Roth IRA can serve as a temporary emergency fund while you do not have the emergency fund build up all the way.

Most people do not say that all Roth IRA contributions are available for withdrawal anytime without taxes or penalties. Only the earnings on those contributions will incur penalties if withdrawn early. However, this is true.

Therefore, If you have an excess of $500 a month after fulfilling all your expenses and the 401(k) contribution (if it has a match). You have no emergency fund and you require an additional $300/month in retirement savings to be able to save the suggested 15% of your gross income. Instead of putting the entire $500 towards the emergency fund, put $300 in a Roth IRA and $200 in the emergency fund.

If you have a serious emergency such as a job loss or a medical accident you cannot cover, remember that you can withdraw the $300/month you have been putting in to the Roth IRA. The danger in this is that your holdings can go down. Therefore, you can hold all of your Roth IRA investments in cash until you have build up your emergency fund. The more real danger is that you will now always see your Roth IRA as an emergency fund and will empty it if an "emergency," such as a friend's wedding, arises. Don't ever take money out unless it's a real emergency. Remember that you can never replace it.

The main reason for this maneuver would be that if your emergency fund needs 8 months of expenses, then you will need a year or two to build this up. You can only contribute $5K in a Roth IRA per year and if you do not contribute one year, you miss out on that amount.

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