The primary purpose of Roth IRAs is indicated in the title: IRA stands for individual retirement arrangement. However, by virtue of favorable tax rules and early-withdrawal exceptions, a Roth IRA can serve as a backup vehicle for pursuing multiple savings goals, when necessary or with strategic planning.
This is particularly relevant to savers who are just beginning to build longer-term savings or for clients who seek a more flexible retirement savings option that allows access to their savings prior to age 59½ in certain circumstances. The ideas presented in this article can help ease the inherent conflict among savings priorities for those who don't have enough financial bandwidth to save for multiple goals at once, but who want to set themselves up to have the most flexibility in their future choices.
Backup emergency fund
Lower-income and early-career savers are often faced with a choice of either increasing emergency savings or contributing to a retirement account. A Roth IRA can serve both ends because contributions made directly to a Roth IRA can be withdrawn at any time without tax penalties or consequences (this applies only to prior contributions, not distributions taken from earnings). Thus, simply making an eligible Roth IRA contribution can serve the same purpose as depositing the savings in a cash savings account until adequate savings are accumulated outside the Roth IRA.
Two important caveats must be noted with this strategy. First, funds that are contributed to a Roth IRA for the dual purpose of saving for retirement while also providing funds in the event of an emergency should not be invested in the market until the account balance exceeds an appropriate amount for emergency savings or ample savings have been amassed outside the Roth. By employing this strategy, the saver is essentially planning for future tax-favored investing capabilities while taking advantage of Roth contribution eligibility that may be limited in the future.
The second caveat is that this strategy works best with funds directly contributed and not through a conversion, including "backdoor" contributions. This is because Roth IRA funds that are converted from a traditional IRA have a five-year holding period before the amount converted that was included in income can be withdrawn without being subject to early-withdrawal penalties (regardless of the age of the account holder). Because of the five-year rule, a Roth IRA created through conversion would have limited usefulness as a backup emergency fund.
First-time home purchase
Both traditional and Roth IRAs provide an exception to the early-withdrawal penalty by allowing account holders to withdraw up to $10,000 for a first-time home purchase, but the Roth IRA can provide more than that, if needed, without the taxable income. Since the $10,000 exception applies to funds that would otherwise be subject to the 10% early-withdrawal penalty, this means that a first-time homebuyer could withdraw up to $10,000 in account growth plus any contributions made; depending on the amount of prior contributions, this could be a sizable amount.
In other words, if you have a client who has contributed $35,000 to his or her account to date, the first-time home purchase withdrawal could be up to $45,000 without taxes or penalties.
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 ending on the date of acquisition of the principal residence. This means that if a married couple are buying a jointly owned home and either partner owned a primary home in his or her individual name in the prior two years, the exception does not apply.
The $10,000 exception has a once-in-a-lifetime limit, and the Roth IRA has to meet the five-year rule, so anyone using this strategy will want to make sure they meet the requirements before making withdrawals from the earnings of a Roth IRA. There's also a time limit on when the home must be purchased after the withdrawal is made, so planning ahead is crucial.
Of course, a cost/benefit analysis should be done when determining whether it makes sense to use retirement savings to purchase a home, so this strategy should be used with caution. Using Roth savings 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. But if a Roth is being used for a purchase that is a financial stretch, that could be an indication that owning a home may not yet be financially prudent for the client.
Backup education savings plan
While a Roth IRA is not typically a sufficient savings vehicle for all education costs that a family may incur, it can serve as an excellent supplemental savings plan for families who have uncertainty around how much savings they may end up needing for future education costs. Similar to the traditional IRA, Roth IRA funds can be withdrawn for qualified education expenses without the early-withdrawal penalty, but any funds taken from earnings will be taxed as ordinary income.
In families where the need to provide education funding is uncertain or where a family may otherwise qualify for need-based financial aid, a Roth IRA can be a flexible way to save for college without having to spend the funds on college — in other words, if the student doesn't end up needing the financial help, then the account owner has a boost to his or her retirement savings.
Whether to use a Roth IRA for education expenses will depend greatly on the client's individual situation. It's a commonly accepted rule of thumb to prioritize retirement savings over college costs, but in cases where a client is otherwise on track to retire without the Roth IRA as part of the plan, it can be a strategic use of a flexible savings vehicle.
In summary, while a Roth IRA's purpose is primarily to fund retirement, with strategic use, it can be a flexible way to plan for multiple life possibilities, especially for clients who are just starting out on their savings journey toward future financial independence.
— Kelley C. Long, CPA/PFS, CFP, is a personal financial coach in Tucson, Ariz. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.
