Using your Traditional IRA as an Emergency Fund- Is it the best plan for you?

Save, Save, Save is the mantra everyone hears from the ripe old age of about 5 until the day you retire.  Put money into investments and watch them grow, compounding each month and when you are 65 you will be a millionaire.  This is excellent advice and a goal everyone should aspire to with every paycheck.  The problem that arises is when people dump all of their savings each month into investment vehicles like 401k’s, Traditional IRA’s, etc.  and “life and Murphy” decide to slap them in the face a couple of times and they are faced with some type of emergency.  The first thing a lot of people will do is  run to these saving vehicles that they have been trying so hard to build up and deplete them without knowing the actual consequences of doing so.

I see it every year, people will sit with me at tax planning time and will tell me  they had their transmission go out or some other emergency happen and they had to take money out of their Traditional IRA’s to fix it.  They say to me that they know it wasn’t a good idea and expect some type of penalty and tax, but have really no clue of what those consequences may be.

So let’s talk about what happens if you are using your Traditional IRA (Roth IRA’s have some different rules) as an emergency fund and have to take out the money before age 59 ½.  Unless you meet one of the IRS’s criteria for penalty free distributions (to be listed later), any early distribution from your Traditional IRA will be taxed at your current tax rate AND will be assessed a 10% early withdrawal penalty.

Let’s look at an example:

You get a bill for the transmission repair for $3,500.  You decide to get a check from your Traditional IRA and give it to the repair shop.  The actual cost of this repair quickly becomes:

Repair of Transmission  $                    3,500
Tax on distribution (estimated 15% tax bracket)  $                       525
State Tax (estimated 6% tax bracket)  $                       210
10% Early Withdrawal Penalty  $                       350
New total for repair  $                    4,585

The decision to use your Traditional IRA as an emergency fund has cost you an extra $1,085 for the repair.

What could be an alternative to using the IRA as a method of emergency funding?  My suggestion is to start with saving up $1,000 and putting it into an “emergency savings account”.  This $1,000 will help cover most of the emergencies that we may face on a daily basis.  The idea of having $1,000 in an account for those small aggravating emergencies will help alleviate so much stress for the average American.  Then as your discretionary income increases and your debt are paid down, regularly add to your emergency fund until it is equal to 306 months of your living expenses.  This emergency fund will help hedge those “Major” emergencies that people face, like transmissions going out, job layoffs, etc.

As mentioned earlier, there are some instances where the IRS will waive the 10% early withdrawal penalty, the most common exceptions from the IRS are:

  • First-time home purchase
  • Qualified education expenses
  • Death or disability
  • Unreimbursed medical expenses
  • Health insurance, if you’re unemployed

While these exceptions are available, the amount taken from the Traditional IRA will always be taxed at your current tax rate.

A full listing of the exceptions can be found on the IRS website at https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions

If this topic is daunting and confusing, or you are contemplating having to take a withdrawal from your Traditional IRA, and want to talk through the decision, please call us for a free consultation at 541-326-0993.