Keep Savings Aside from Retirement Accounts

You shouldn’t have all your savings in retirement accounts. You need to keep some of your money outside retirement accounts for emergencies.  There are several reasons for this.  The main one is if you have to pull money out of your retirement accounts for an emergency you will get hit with a large tax bill.  On a 401k you’d have to pay a 10% penalty plus ordinary income tax on the amount you withdraw. This could eat up almost half of your withdrawal.  On a Roth IRA you’d also have a 10% penalty but you’d only owe ordinary income taxes on your withdrawn earnings not your contributions.  There are exceptions that will let you avoid the penalty but they won’t apply to most withdrawals.

The other big reason to avoid pulling money out of your retirement accounts is that you lose the ability to contribute that amount to your retirement accounts.  If you put $5,000 in your Roth IRA and then have to withdraw it you can’t put it back in.  You’ve lost the ability to contribute $5,000 to your Roth IRA for that year and you’ll have to wait until the next year to start contributing again.  Since you are only allowed to put a certain amount in retirement accounts it is important to make full contributions if possible.

Those are just the biggest drawbacks to using your retirement accounts as an emergency fund. Some people think it is worth the risk to keep all of their savings in retirement accounts but I wouldn’t recommend it and it isn’t what I do.  I may not be able to fully fund my Roth IRA this year because I don’t want to bring down the balance of my non-retirement savings too low.  There is a drawback to this too because I’m losing the ability to contribute that amount.  What would you do, keep a fully funded emergency fund or withdraw most of it to contribute to a Roth IRA?