Backdoor Roth Emergency Fund
Backdoor Roth IRAs can be part of your Emergency Fund!
Roth money is precious.
Paying taxes now ensures tax-deferred growth in the future and tax-free distributions later in life. Tax-free distributions can be hugely important in the future to control your income. If you want premium ACA credits for health insurance, or avoid IRMAA, or pay less taxes on your social security, you can take money out of your Roth as a tax-free income to pay bills.
Every year you have the opportunity to tuck a small amount of money away in a Roth IRA. If you are over the income limits, use a backdoor Roth IRA instead. Don’t miss out this year! Every year, especially when you are young, take advantage of the $6,000 ($12,000 for a couple) you can squirrel away.
What if you don’t have a fully-funded Emergency Fund?
Do a backdoor Roth anyway, and use the backdoor Roth Emergency Fund.
What is an Emergency Fund?
An emergency fund is there if you hit hard times. Most high-income earners can cash flow an emergency, and the size of an adequate emergency fund is greatly debated. Some keep a month of expenses in cash while others have 2-3 years.
How much emergency fund do you actually need? It depends!
If your job is stable and income appears in your bank account every two weeks, you may not need much. For self-employed or variable income folks, it might be nice to have a chunk of change waiting for a stretch of bad months.
If you are married and both work, it is unlikely both partners will lose their job at the same time. Unless, of course, both work for the same company (or even in the same field).
A couple who is using both incomes for lifestyle “needs,” however, is most at risk. That is, if both spouses’ income is necessary to pay the monthly bills, trouble lurks if either of them has a hiccup and the emergency fund should be well funded.
Contrary to common beliefs, a couple with a single income earner and a “stay at home” spouse may not require a large emergency fund. If the primary bread winner gets fired, often the stay at home spouse can use his or her talents to find a J-O-B to tide them over.
So, an emergency fund is 1-6 months of floor expenses. You can cut back on lifestyle choices (eating out, travel), but not on necessary bills that arrive every month. This include insurance premiums, but likely not investing for retirement or other items you can put on hold for a few months while you get back up to speed.
What is a Backdoor Roth Emergency Fund?
So, since Roth money is precious and cash may be hard to come by early in your career, what should you do?
Consider the backdoor Roth Emergency Fund.
That is, fund your (backdoor) Roth every year, and invest it in non-volatile assets.
Again, ever year there is a limited amount you can put in a Roth, and if you miss it this year, the opportunity is gone forever.
And, you can always withdrawal your contributions to your Roth IRA tax and penalty free—even your backdoor Roth!
Yes, backdoor Roth IRA contributions can be withdrawn tax and penalty free for any reason.
Hear me out—I am NOT suggesting you PLAN to use your Roth money. But as a part of your emergency fund, in a pinch, you can access your contribution to a frontdoor or a backdoor Roth to pay bills.
Wait, I can Withdrawal my Contribution to a Backdoor Roth IRA?
YES! The answer is hard to find on the internet. When you do find it, you get all sorts of judgmental people saying “well why would you even consider doing that.”
Yes, we get it. Roth IRAs are retirement accounts and for the future and not a revolving door.
But if you have the choice to either fund or not fund your Roth IRA this year, FUND IT—even if you don’t have a full emergency fund.
Let’s review the basics. As I said, the answer is hard to find and there is lot of confusion on-line about backdoor Roth IRAs.
First off, it is a contribution, not a conversion. A conversion happens in the second step, but the intent (the reason you go through the backdoor) is because you make too much money to directly contribute through the front door.
Secondly, you can pull your basis out. Since you are contributing post-tax money (rather than paying taxes on pre-tax money), the five-year rule doesn’t apply. So, you CAN use your backdoor Roth as an Emergency Fund.
Let me unpack that a little, because most of what you read on the internet is wrong.
Evidence to Support Withdrawal of Basis
I love the Retirement and IRA Show and asked them if you could withdrawal your basis in a backdoor Roth. They initially got it wrong but something in the back of Jim’s head got Chris to do some research and they get the right answer eventually.
Folks get sidetracked with the 5-year rules. There are two flavors of 5-year rules. The first is for any Roth account, and it says you cannot get earnings out unless you have had a Roth account for 5 years. This is for contributions and conversions (including roll-overs) but remember just applies to earnings, not the basis or contributions.
The second 5-year rule is for conversions only. You need to wait 5 years to get any money out without penalties. The point here is to prevent people from getting around the 59 ½ year 10% penalty by converting their IRA to a Roth (and paying taxes on it) and then just pulling it out.
However, basis conversions are explicitly excluded from the second 5-year rule.
So that means you can pull-out AFTER-TAX Roth Conversions, just not PRE-Tax Roth conversions that you convert by paying tax on them.
Bogleheads has about the only conversation on a blog that I can find that is accurate on this topic.
Otherwise to find the answer, head to the IRS’s 62 page document on IRAs.
Publication 590-B has the answer on page 30, but be careful reading the source document as it will cause headaches and confusion.
Conclusion Backdoor Roth Emergency Fund
So, you can use your backdoor Roth and an Emergency Fund. But should you?
YES! Again, Roth money is precious. Get your 6 or 12k in the Roth this year, and in a real pinch, you can use it for an emergency.
Since the money may be used in the short term, don’t invest it in volatile assets like equities. Consider using the sweep money market account. Do check the interest rate on the account as I have heard that some folks (Schwab) stick it to you in the sweep account and pay very little. Or, consider a short to intermediate term bond fund with low volatility.
Don’t plan to fail—plan to succeed! Get your money contributed to a Roth every year you can for tax-deferred growth and tax-free distributions in the future. And, if worst comes to worst, you can always take your contribution back out.