Is the Roth IRA the “Swiss Army Knife” of Saving?

So, you have a few hundred dollars to save but you are not sure what to do.  You have been given lots of “advice” and this just seems to make things even more confusing.  You have probably been told you need an emergency fund of 3-6 months of expenses.  You know you need to save for retirement.  Maybe you have children you would like to help pay for their college.  What should you do?

If you are like a lot of people you probably have several goals you want to accomplish but you are not sure where you want to start.  So, depending on what the goal is you might be directed to a different type of savings or investment accounts.  There are retirement accounts, after tax investment accounts, bank accounts, and education savings accounts.  So, with this mindset you need to open several different types of accounts to reach all of your goals.  What if there was one account that you could use to accomplish all of these goals?

I would like to propose that you look at the Roth IRA for this.  I can hear the sceptics already, those are for retirement!  That’s for when you are old and can’t help me save for my first-time home, sending my kids to college or be used for an emergency fund.

So here is how most financial people explain the Roth IRA to a prospective investor.

  1. You put your money into account after tax
  2. It will grow tax deferred
  3. You can save up to $5500 if you are under 50 and $6500 if you are over, based on your earned income.
  4. If you leave it in the Roth IRA until you are 59 ½ or 5 years whichever is longer it will come out tax free.
  5. It you don’t follow the rules in 4. You will pay taxes and a 10% penalty on the gains.

I can hear you saying now look at number 5. A Roth IRA is only for retirement.  Well let’s take a closer look.

Before I explain why I think you should give the Roth IRA more respect, I do want to say that each person’s plan is individual.  There are many types of plans and you should work with an advisor that is qualified to help you build a plan for you.  I just want to say don’t overlook the mighty Roth IRA and think it is only for retirement money.

Let’s take a look at some reasons why I think you should add the Roth IRA to your list of choices.  First, I want to start with building an emergency fund.  I would define an emergency fund as a pool of money you will only use for an unforeseen event that is going to cause you financial hardship “emergency”.  Needing new tires for your car or a home remodel are not emergency fund worthy.  I would normally think about things like losing your job or a health event.  I am from Washington Illinois and we had a devastating tornado in 2013.  Many families were displaced and not everyone was as well insured as they thought they were.  This is the time when you hope you had that emergency fund.  So how can saving in a Roth IRA help me build my emergency fund.  You can invest your money in many different ways.  If the money you are saving is geared towards an emergency fund you will want to use much more conservative investments because you don’t know when you will need it.  As the account grows and you now have the 3-6 months set aside you can start to invest new money for other goals.  Why use the Roth instead of just putting it in the bank?  Well the money grows tax deferred.  If you decide to switch around the investments, you don’t pay any taxes on the exchange.  Also, I have found that when people have their emergency fund mixed with their regular savings the emergency fund often gets used for things it shouldn’t.  You are much less likely to touch it if is part of your Roth IRA.  But what about those tax penalties, if I am not 59 ½ and I need to take money out.  Did you know you can pull out the principal without penalty, and it comes out first.  So unless you pull out all of your principal and then start to pull out gains, you won’t pay any tax or penalty.  So as long as you can stick to only taking principal only you can leave those gains until you are over 59 ½ and they can come out then tax free.

What else can I use my Roth IRA for?  If you have a Roth IRA and are looking to buy your first home, there are some special benefits for you.  When we talked about the emergency fund I told you that you can take the principal without paying taxes, and of course you could do that same thing when buying a home.  There is a special provision for first time home buyers that is even better.  A first-time home buyer can take up to $10,000, even if it is the entire account and not pay any taxes or withdrawal penalties.  Pretty sweet Right!

So, both of those are pretty interesting, but what about saving for college.  Again, principal can be taken out without taxes or penalties.  Some of my clients will fund their Roth IRA with the idea that they might use the money they put in (principal) to fund their children’s education but any of the gains are mom and dad’s retirement money.  If you followed this plan you would not pay taxes on any of the gains.  What if this wasn’t enough and you needed to use some of the gains.  You could take those without the 10% penalty, but you would still pay taxes.  Are there any other benefits to saving for college in a Roth IRA? 

Currently retirement account balances are not counted when applying for financial aid vs a 529 plan that would be counted as an asset when applying for aid.  Keep in mind that while the balance does not count against the student for financial aid calculations any distributions will 2 years after they are taken out.  So, you may consider waiting until spring semester of the student’s sophomore year (if they are on 4-year plan) before making distributions.  Of course, this is more complicated if you have multiple children going to college.

I hope after reading my article, you will consider how the Roth IRA can fit in your plans, in ways you may not have previously considered.  Please keep in mind that everyone situation is different.  I am also not saying the Roth IRA is the only solution.  You should work with an advisor that can help you determine if any of this is right for you.