CFP®, RFC, CSA
Senior Financial Advisor
If you are like many other people you have more goals than resources available to meet those goals. As a result many of us must make the decision of which goals take priority, and how we can best achieve those goals. For example, if you had to choose between contributing $5,000 to a Roth IRA and keeping/putting it towards your Emergency Fund, which would you choose? Let's assume you don't have the funds to do both. Many people put Emergency Fund near the top of their priority list, just below taking advantage of any "free money" via a 401(k) match, but above other retirement savings. This is because in the event of an emergency you don't want to dip into retirement accounts and face 10% early withdrawal penalties and applicable taxes, or otherwise be faced with other forms of high interest debt like credit cards or personal loans if you need money urgently.
However, the annual $5,000 Roth IRA contribution limit is a "use it or lose it" proposition. In other words if you do not contribute this year, you are not allowed to contribute twice as much next year. Once April 15th rolls around, you've missed out on potential tax advantages.
Please don't misunderstand me, an emergency fund is and should be a greater priority than saving for retirement. However, I believe you can make steps to accomplish both goals using a ROTH IRA. Here's my reasoning. Let's say you go ahead and contribute $5,000 to a Roth IRA but leave it invested in something safe like a money market fund or CD. Now, there are basically two possible resulting scenarios after you do this:
You end up needing the money
No problem, you can always withdraw your Roth IRA contributions without any penalty. Just take out what you need, up to your contributed amount, and leave the rest in the account. Assuming you invested in a safe investment, like the money market, it will not have decreased in value due to stock market volatility. You'll still lose the tax advantages on any withdrawals, but you would have missed out had you simply invested in the money market outside of a Roth IRA anyway.
More likely than not, you won't need all the money, and hopefully within a year or so your emergency fund will be replenished from other sources. Now, you can start really taking advantage of the Roth IRA's tax benefits and move to riskier investments with higher returns.
Come to think of it, couldn't you take this same approach for college education savings?
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