Oblivious Investor Guest Post: Raiding the Roth IRA for Emergencies: Weighing Pros & Cons

Mike Piper is the author of Investing Made Simple. He blogs at The Oblivious Investor, where he encourages readers to invest via low-cost index funds and ETFs.

Tell me if this sounds familiar:

· You have not yet maxed out your 2009 IRA contribution,

· You have cash that you could contribute to an IRA, but

· You’re not sure you want to tie the money up in an IRA, because there’s a chance you’ll need to spend it in the not-so-distant future.

If that’s your situation, it might not be so crazy to go ahead and contribute that money (or a portion of it) to a Roth IRA.

But what about taxes and penalties?

It’s “common knowledge” that money in an IRA must be left there until age 59½ in order to avoid penalties. The thing is, that’s not entirely true.

Contributions to a Roth IRA–that is, money that you put into your Roth–can be withdrawn at any time, free from tax and free from penalty. It’s only for withdrawals of earnings (i.e., interest and growth on the investments) that you must jump through hoops in order to avoid tax and penalty.

(Related Resource: Roth IRA withdrawal rules.)

But what about losing money?

Because there’s a chance that you’ll need this money in the near future, you don’t want to invest it in anything risky. Steer clear of stocks, stock mutual funds, and so on. In fact, I’d even avoid most bond funds.

A better choice would be to put it into something with extremely low risk–a no-load money market fund, for example.

Note: Unlike savings accounts or money market accounts, money market funds are not FDIC insured. They are, however, required by law to invest in low-risk securities such as short-term government debt and certificates of deposit.

How quickly can I get to my money?

Of course, if there’s a chance that you’ll have to spend this money, you want to make sure you can actually get to it when you need it.

When you sell your holdings in a mutual fund, the sell order will be executed at the close of trading for the day. (If you place the order after trading has already closed, it will be executed at the end of trading on the next business day.)

After that, you’ll have to request an electronic funds transfer to your checking account. That adds another business day to the wait time.

In other words, depending upon when you place your sell order, it’s possible that you’ll have the money in your checking account and ready to spend in as little as two days. On the other hand, because of weekends and holidays, it could take up to several days before you get your hands on your cash.

Conclusion

It’s not a good idea to use a Roth IRA as your only emergency fund. You absolutely must have some money somewhere that is both completely safe and quickly accessible.

If, however, you already have a modest emergency fund in a savings, checking, or money market account, it may make sense to go ahead and make a Roth contribution before the deadline passes by. Just be sure to invest the money in something with very low risk.

Later, if/when you reach the point that you know you won’t need the money in the near future, then it can make sense to move it into riskier, long-term investments.