As I watched, a young, single woman who had finally paid off all of her credit card and student loan debt, was being advised on what to do with the money she had saved for emergencies. I listened as the show’s famous host told the woman that in order to have easy access to her money, as well as to benefit from tax free compound interest, the woman should put her emergency fund into a money market account within a Roth IRA.
WHAT??? SERIOUSLY??? NO!!!
It felt just like the time when Matthew Crawley lay still and bloodied on the road back to Downton! I found myself yelling "NO,NO! " at the TV, as my mind raced for a way to travel through time and airwaves, and land on the set to make things right again!
Regretfully, teleportation and time-travel are not my forte, and I remained in New England throwing slippers at my television, as the poor woman in audience thanked the famous host for being wonderful, and went off to jeopardize her financial future.
Hopefully, I can save you, my readers, from the same financial fate. So, without further ado, here is what you should really do with your emergency fund, and why a Roth IRA is a terrible place to put it:
1. Put your emergency fund in a money market account at a local bank or credit union, and keep it out of your Roth IRA.
Money market accounts are similar to savings accounts in that they offer safety and easy access to your money, yet they differ from savings accounts in that their rates are usually tiered, so the bigger your balance the bigger the interest rate you receive. Keep in mind that by “bigger”, I mean “still extremely small”. In investment land, the more risk you take on, the more an investment has the potential to gain or lose money. Since money market accounts have no market risk, they also have no potential for big gains. But that is OK, we don’t need this money to grow, we need it to be safely held and easily accessible to us in case of a financial emergency, to cover our expenses for a set period of time while we get back on our feet.
2. Roth IRAs are for growing money, not holding money. Use your annual contributions to grow your money!
Roth IRA’s are for growing money, because we do not have to pay taxes on the growth. Since we only get to put a limited amount of money into these accounts each year, it makes sense to leave the "holding money" job to money market accounts outside of our Roth, where the low earnings also mean low taxes to pay, and give the "growing money" job to all of the investments inside of our Roth, where high earnings put the tax savings opportunity where it can do the most good.
Let's think of it this way, suppose you are a farmer, and you have two jobs. You have to grow a cabbage, (your emergency fund) and you have to grow a 360 foot beanstalk (your retirement savings and investments). Now suppose that each year you get one bag of fertilizer (your Roth IRA contributions with their tax free earnings) that you can use as you wish. Will you use this fertilizer on a cabbage when you have a giant beanstalk to grow? Of course not!
Here is another example, suppose in January of this year you contributed the maximum of $5,500 into a well regarded moderate risk mutual fund within your Roth IRA. As I write this that amount would have grown by about 8%, or $450. Since you do not have to pay taxes on this growth, depending on your tax rate, you would save somewhere around $120 dollars in taxes by having this money in a Roth IRA. Meanwhile, had you put that same $5,500 into a money market account, in your Roth IRA or not, it will only grow at a fixed rate (currently around .3% for the year), so you would have made about $12 in interest to date. Depending on your tax rate, using your Roth contributions to fund your money market would have only saved about $3 in taxes. Use your annual Roth IRA contributions to grow your money and to grow your tax savings. Use your money market account outside of your retirement accounts to hold your emergency fund.
3. Taking money out of an IRA before retirement is a dangerous habit to get into.
We are creatures of habit, in an on-demand society. It is already difficult enough for most of us to avoid impulse credit card buying, or parting with our cash for a non-immediate use, never mind leaving it alone for decades in a retirement account. Saving money is hard! Suggesting that we actually earmark Roth IRA retirement savings for emergencies not only clogs up our opportunities to grow our retirement funds, but it also sets our minds to thinking that we can use those retirement funds now if we need to. But we can't! Most of us are all too familiar with how easy it is to blur the line between want and need, that is how we get into all that credit card trouble! The first time you dip into your Roth Emergency Fund it might be to repair the car that broke down, then next time is when the kids need braces, and before you know it you are taking money out to buy furniture, a new outfit or birthday presents! Retirement money needs to be considered off- limits until we are retired. so that we have the financial stability we will need when we are too old to work!
Let’s face it, most of us are already swimming against the tide when it comes to saving money. Let’s not make underfunding our retirement any easier than it already is!