Roth IRAs Beyond Retirement

Take-Away: While a Roth IRA is normally viewed as being strictly used for retirement purposes, it can also act as a flexible backup account. Thus, a Roth IRA can serve a dual purpose of  accumulating funds for retirement, or act as a savings account when funds are needed long before retirement is reached.

Background: We are all familiar with the favorable tax rules associated with Roth IRAs and the exemption the Roth IRA owner has from having to take required minimum distributions (RMDs) from their account. Another way to look at Roth IRAs is as a more flexible retirement savings option, that allows access to the Roth ‘savings’ portion prior to age 59 1/2 in some situations. Common situations where owning a Roth IRA might be beneficial (beyond retirement) include the following.

1. Rainy Day Fund: Lower income and early-career savers are frequently confronted with a choice to either increase emergency savings or contribute those limited funds to a retirement account. A Roth IRA can meet both purposes, because the contributions the owner makes directly to his/her Roth IRA can be withdrawn at any time without tax penalties or consequences.  However, it is a different story with regard to the withdrawal of earnings from a Roth IRA, for which there is a 5-year holding period before the earnings can be withdrawn tax-free. In short, simply making a Roth IRA contribution can serve the same purpose as depositing cash into a savings account.

– Caveat #1: The funds that are contributed to a Roth IRA for the dual purpose of saving for retirement while providing a source of emergency funds should not be invested in the market until the Roth account balance exceeds an appropriate amount for emergency savings, or ample savings have been accumulated ‘outside’ the Roth IRA. This enables the Roth IRA owner to essentially plan for future tax-favored investing capacities while taking advantage of his/her Roth contribution eligibility that might be limited in the future by Congress.

– Caveat #2: This dual purpose strategy works best with funds directly contributed and not through an IRA conversion or a ‘backdoor’ Roth conversion. This is because Roth IRA funds that are converted from a traditional IRA to a Roth IRA face the 5-year holding period before the amount converted that was included in income can be withdrawn without bending subject to early-withdrawal penalties, regardless of the age of the Roth IRA owner. Thus, because of this 5-year holding rule, a Roth IRA created via a conversion would have limited use as a backup emergency fund.

2. First-Time Home Purchase: Like a traditional IRA, a Roth IRA provides an exception to the early-withdrawal penalty. The exception allows the retirement account holder to withdraw up to $10,000 for a first-time home purchase. However, the Roth IRA can provide more than that, if needed, without taxable income. The $10,000 exception applies to funds that would otherwise be subject to the 10% early-withdrawal penalty. Accordingly, the Roth IRA owner could withdraw up to $10,000 in Roth account growth, i.e. earnings, plus any contributions directly made to the Roth IRA account.

– Example: Barbara has contributed $35,000 to her Roth IRA. The Roth IRA balance is now $55,000. As a first-time homebuyer, Barbara could withdraw up to $45,000 from her Roth IRA to be used towards the purchase of her first home, without taxes or penalties.

– Caveat #1: The IRS considers a first-time homebuyer to be someone who has not owned (and, if married, whose spouse has not owned) a principal residence during the two-year period that ends on the date of acquisition of the principal residence. Thus, if a married couple are purchasing a jointly owned home, and either spouse owned a home in his/her name during the prior two years, then this $10,000 exception will not apply.

– Caveat #2: There is a time limit on when the home must be purchased after the withdrawal is made from the Roth IRA. Therefore, it is important to plan far ahead.

– Caveat #3: This $10,000 exemption has a once-in-a-lifetime limit. The Roth IRA also has to meet the 5-year holding rule, so any Roth IRA owner who plans to exploit this opportunity will want to make sure that they meet all of the holding requirements before they take any withdrawal from the Roth’s earnings.

– Caveat #4: The decision to use retirement funds to purchase a home may not make much financial sense. Using Roth IRA funds for a home purchase can make sense if interest rates and other retirement savings offset the opportunity cost of the potential loss of future investment growth in the Roth IRA.

3. Education Savings Plan: A Roth IRA can also serve as a supplemental savings plan for a family that is uncertain how much savings they need to accumulate for future higher educational costs. Like a traditional IRA, Roth IRAs can be withdrawn for qualified education expenses without the early-withdrawal penalty. Yet again, any funds taken from the Roth IRA earnings will be taxed as ordinary income if the 5-year holding period is not met. If the student does not end up needing the family’s financial help, then the Roth IRA owner has a boost to his/her retirement savings.

Caveat:  It is a fairly common accepted rule-of-thumb to prioritize retirement savings over college education costs. Yet where the Roth IRA owner is on track to retire without the Roth IRA as a critical part of his/her retirement plan, the Roth IRA as a source of funds to pay higher education costs can be a strategic use of this flexible savings vehicle.

Conclusion; We appropriately consider a Roth IRA to be a retirement savings vehicle.   Not to be overlooked, though, are situations when a Roth IRA can also be a highly flexible source of funds that can be accessed to deal with financial emergencies, the purchase a home for the first time, or to help pay for children’s education. It serves a dual purpose of saving for retirement, and also as a readily accessible source of funds when life throws us some curveballs.