The mantra of personal finance books and financial personalities is to fund an emergency fund with $1000 initially and then up to six months of living expenses. This is rock solid advice with the final amount for your rainy day fund dependent on job stability. Traditional advice directs a person to put that money in a bank savings account earning an interest rate below the rate of inflation. The Bureau of Labor Statistics lists the 2017 median wage for workers in the United States as $44,564 with the Census Bureau reporting a median household income of around $56,516 in 2015.
This could result in six months of expenses, possibly $20,000 or more, just sitting in a bank account with a dismal rate of return. As the money is slowly losing buying power because of inflation, the earned interest is being taxed each year as earned income. Possibly, the most horrific consequence of all, is the impact on retirement. Retirement is impacted because the funding of one or two years of a Roth IRA may not get accomplished. In the spirit of education, I will share my thoughts and offer up a few alternatives to have readily available cash while funding a Roth IRA to build long term financial security.
The glorious Roth Individual Retirement Arrangement (IRA) is also known as a Roth Individual Retirement Account. This personal investment arrangement is named after Senator William Roth and was established in 1997. I describe the Roth IRA as personal investment to hammer home the point that it has nothing to do with a Roth 401K or a Roth TSP that are established through work. In the simplest and generalized terms, this personal arrangement goes through these steps:
A person’s income is taxed.
The taxed money is invested into stocks, bonds, CDs or money market accounts within a Roth IRA.
The investment is positioned to grow tax free and never generates a 1099 as long as the certain conditions are met.
A withdrawal at age 59 years and 6 months is tax free money. The government decided to take or tax your money upfront and then allow a person to keep the entire amount when future withdrawals are taken.
A key characteristic of the personal Roth IRA is that direct contributions can be withdrawn or removed at any time. Therefore, if I contribute $5,500 into a Roth IRA in January, I can remove that $5,500 penalty-free at any later date. Why is that possible? The reason is that $5,500 was already taxed by the good old U.S. government.
I am a fan of companies that that offer low-cost investing because expenses matter over time. Based on my research and belief in index investing, my wife and I use Vanguard for our personal Roth IRAs. Other low-cost companies are Fidelity, T. Rowe Price and Charles Schwab. For more details, I recommend visiting Clark.com. Clark Howard provides a good review on these financial institutions and more in depth details of the Roth IRA.
The “rainy day” or emergency fund should be a pot of money that is safe and accessible to deal with unexpected life events without creating debt. My thoughts on saving options:
Bank or credit union savings account an option that will return the lowest amount of interest. At this time, these institutions pay 0.15% annual interest rate for low risk. You can do better.
Online banking account This option pays around 1.5% annual interest rate for low risk. Bankrate and Nerdwallet are examples of a website to review current rates. I use an online bank and selected one that was FDIC insured, received a good rating and historically has top tier rates. Ally, DollarSavingsDirect and Charles Schwab are examples with many good options to choose from.
Series I Savings Bond Treasurydirect.gov provides good information. This option will have an annual return that meets or exceeds the rate of inflation with low risk. However, this money is locked up for a year and incurs a 3-month loss of return penalty if redeemed between years 1 5. I purchased some bonds in 2000 when the fixed rate for I-Bonds was 3.4% plus the rate of inflation. This is a viable long term option to slowly buy into as interest rates rise and inflation returns to historic norms.
Roth IRA The annual contribution can be withdrawn at any time penalty free. The contribution also grows tax free; therefore no 1099s at tax time. The risk is directly proportional to the type of investment selected. Please remember that the investment can start with a money market account and be move to a more aggressive stock fund at a later date. Funding or investing can be accomplished for each calendar year until April 15th of the following tax year. Therefore, a person is allowed to contribute to a 2017 personal Roth IRA by April 15, 2018 or tax day. After tax day, only a 2018 Roth IRA can be funded.