Why You Should Fund a Roth IRA Even if You Think You Can't Afford It

by Michael on Mar 25, 2013 · 4 comments

Photo of a $100 Bill Being Stretched

Tax day is three weeks away. This means that you have two weeks to fund an IRA and have it count toward the 2012 contribution limit.

If at all possible, you should do this. Why? Because once the window closes, you can’t go back and make up for a missed contribution.

If you’re concerned about spreading yourself too thin, consider funding a Roth IRA. I say this because the rules governing Roth IRAs allow you to withdraw your contributions at any time and for any reason.

That’s right. You can withdraw your contributions whenever you want and whyever you want. Without penalty. Details can be found in IRS Publication 590.

In general terms, I view this rule as somewhat of a liability. After all, the point of an IRA is to save for the future. You’d thus be doing yourself a serious disservice if you raided it to buy a boat, remodel your kitchen, or go on vacation.

But the ability to withdraw your contributions does gives you the flexibility to contribute to a Roth IRA even if you’re not sure that you can afford it.

So even if you have to dip into your rainy day fund, there’s little risk in funding a Roth (assuming you heed the final bullet point, below). Just make the contribution, cross your fingers, and save like mad.

If all goes well, you’ll lock in that contribution and re-build your cash cushion before your need to dip into it. And if something goes horribly wrong, you can always contact your IRA custodian and ask for your contributions back.

Some important considerations:

  • Be sure to do this with a Roth IRA. The withdrawal rules are different (much more strict) for traditional IRAs.
  • Be aware that only original contributions are subject to such lax treatment. To withdraw conversions without consequence, your account has to satisfy the “five year rule.” And the rules are even more strict for earnings.
  • Be sure to respect the current contribution limits. These limits are combined for Roth and traditional IRAs, so be careful.
  • Keep in mind that Roth IRA contributions aren’t tax deductible, whereas you may be able to deduct traditional IRA contributions.
  • Finally, be sure to keep you investments (very) conservative if there’s a chance that you’ll need to access the money anytime soon. You can always ratchet things up once you’ve re-built your cash cushion.

Good luck!

1 Kurt @ Money Counselor March 25, 2013 at 11:48 am

You make a good point; I think the “considerations” you list are a very important part of the post, especially investing money you might need to spend–whether in an IRA or out–conservatively. Hurts a lot to be forced to sell at a loss!

2 Austintatious March 25, 2013 at 2:30 pm

Hi, Michael. I’m in a discussion with my daughter about funding a Roth IRA. She’s just started her own business and her cash flow is not as steady as we’d like, right now, so she well fits the scenario you describe above with someone having limited cash on hand. Despite that, she really does need to get started on a retirement savings program and the Roth IRA seems to be best for her, since we expect that her annual income will grow over time. That last point you make about keeping things very conservative if there’s a chance she might have to dip into the IRA – just how conservative are you suggesting? I’d thought that something like the Betterment program, where she can get in the door with small initial deposit might be an option, or even a target retirement fund like those at Vanguard, though that would require a larger initial deposit. Would something like those options be sufficiently conservative, in your opinion? Thank you.

3 Michael March 25, 2013 at 2:47 pm

Austinatious: Great question. If I was funding a Roth with money from an emergency fund, then I would probably treat it as such until I had time to rebuild that cushion outside the Roth. So if it would be otherwise be sitting in a bank waiting on a rainy day, then I would probably plug it into a money market fund inside the Roth.

Yes, such funds pay practically nothing, but the money won’t stay there forever. The key (in my view, anyway) is to take advantage of the annual contribution before the window closes. Once your non-retirement savings has recovered, you’re no longer at risk of needing to cash in your Roth, so you’d be free to invest it more aggressively.

You could also do this on a rolling basis. For simplicitly, let’s say you have a $5k emergency fund. You go ahead and stick it in a Roth while keeping it very conservative (just in case). Next year, you do the same thing — only now you have $10k in there and you still only need that $5k cash cushion so now invest $5k while holding $5k in the money market fund. And so on.

Does that make sense? Personally, I wouldn’t put any money in the market if I thought there was a reasonable chance that I might need to liquidate within the next five or so years. This puts a drag on your returns, but it’s far better than having to sell after a crash.

Something else to consider: People are perhaps (?) more likely to need to tap into their savings during a major economic slowdown — and economic slowdowns tend to coincide with stock market declines.

4 Austintatious March 25, 2013 at 5:48 pm

Makes good sense. Many thanks.

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