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Emergency savings?
Question: I'm a 28 year old full-time graduate student, married, and proud parent of one son. I receive stipend from school which is not much and is our sole source of income, but with (super!) tight budget we make our ends meet.
One of the things that we'd love to do is to save, even if it's a very small portion of our income. I've heard a lot of good things about the Roth IRA and I think you recommended it to some folks who dialed in to your show. From what I've read about the Roth IRA so far, my understanding is that the Roth IRA allows us to contribute up to $4000 / calendar year and be able to withdraw from our contribution (but not the interest earned) in that same year.
Now, one "wild" idea I had is that since we don't have much of a savings yet but do want to start getting in the habit of doing so, AND also be able to have some level of liquidity with our savings, could I treat my Roth IRA account like a $4000 savings account from which I can withdraw in case of emergencies? I'm attracted to this idea because I'm told that IRA's (mutual funds) typically yield much better returns than conventional savings accounts. Do you think this is wise or am I missing overlooking something fundamental?
Thanks in advance for kindly sharing your wisdom! -John, Baltimore, MD
Answer: Congratulations on your money management skills. And I like your "wild" idea. It's an approach I promote it a lot.
You're absolutely right: A big advantage of a Roth IRA is that it is both a retirement savings plan and an emergency source of savings.
To briefly touch on the basics, Roth contributions are paid with after-tax dollars. The limit for 2008 is $5000. (a $5,000 maximum in 2008 if you're 49 and under and $6,000 if you're 50 and older.) Your investments gains will be tax free when you take the money out during retirement.
Still, in a pinch you can withdraw your Roth contributions without paying a penalty or taxes to Uncle Sam. The key is to leave the investment returns alone. You only tap your contributions. For example, let's say you contribute $3,000 into the Roth and in a pinch you need $1,000. You can take out that $1,000 without penalty or taxes.
About the author
Christopher Farrell is economics editor of Marketplace Money, a nationally syndicated one-hour weekly personal finance show produced by American Public Media.
One problem with this strategy for younger savers: Shouldn't emergency savings be in a low-risk investment vehicle? Generally, mutual funds only have higher returns over the long term, right?
I am 28 myself and started a Roth IRA a year ago. I have it invested fairly aggressively in a distant target-date retirement fund. Thus, in the current market, there ARE no investment returns-- only losses. If I used this account as my emergency savings and actually had to make a withdrawal, I'd have no chance to make up my losses when the market rebounds.
My plan instead is to build my emergency savings in a FDIC insured, high rate (around 3% right now) online savings account. Once I have a solid emergency fund, I will bump my Roth IRA contributions to the limit.
