Roth IRA Not Best for Emergency Savings

Is there any downside to considering contributions toward a Roth IRA as an emergency fund? My understanding is that withdrawals of contributions are penalty-free.

You're right about the tax laws -- you can withdraw your Roth contributions without a penalty or tax bill at any time, so your Roth could act as a source of emergency money in a pinch. You can also withdraw your earnings penalty-free for college expenses and, after your account has been open for five years, you can withdraw up to $10,000 tax- and penalty-free to purchase a new home.

But there is a big downside. Once you remove the money from the Roth, you can't ever put it back in, so you'd lose years of tax-free growth by withdrawing the money before retirement.

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You can only contribute up to $4,000 per year to a Roth IRA ($5,000 if you're 50 or older), and only if you earn less than $150,000 in 2006; $95,000 if single. Married couples can contribute part of the limit until their income reaches $160,000 (or $110,000 for singles).

If you withdraw this year's $4,000 contribution now to pay for emergency expenses, for example, you won't owe taxes or a penalty. But if you'd kept that money in the account for 25 years instead, then the $4,000 could have grown to be more than $27,000 if your investments returned 8% per year -- giving you $23,000 of tax-free money you wouldn't have if you withdrew the $4,000 contribution.

It's better to keep three to six months of living expenses in a separate emergency fund that is easily accessible and can earn some interest. See Where Should I Put Short-Term Savings? for links to online saving accounts that currently pay 4.35% or more.