Hard economic times often call for cold hard cash.
Whether financial pressure comes from rising gasoline and grocery bills, from a period without steady income, or from a mortgage burden, emergency dollars are necessary.
Ideally, investors have a liquid emergency fund. Spending needs to be reduced in difficult times. Beyond that, strategic decisions must be made on where to go next for money.
Credit cards are a terrible source for emergency dollars because they worsen the financial situation through high rates and mounting debt. Pillaging retirement accounts is another mistake you'll regret later in life. As a rule, piling on more debt from any source to pay off other debts can start a downward spiral.
First consideration is the emergency fund. People often don't put enough into it, spend it on non-emergency items or tie it up in investments that carry risk.
"One of the biggest challenges is the temptation of seeing a pot of money, whether $10,000 or $1,000, that seems to be just sitting there doing nothing," said Evelyn Zohlen, a certified financial planner and president of Inspired Financial in Huntington Beach, Calif. "While it is difficult to leave it alone, it must be considered sacrosanct."
Investors should not get clever with emergency money.
"It should be thought of like money in your wallet," said Lance Alston, a certified financial planner with JWA Financial Group Inc. in Dallas. "When people start to think of it as an investment, they make decisions based on return rather than safety and move it around searching for best returns."
For an emergency vehicle, Alston recommends bank savings accounts, bank money-market accounts and the money-market funds of major fund companies or brokerages. Zohlen prefers bank certificates of deposit, noting penalties for early withdrawal are on earnings and not that worrisome.
"The old advice is three to six months of living expenses not earnings, but living expenses," Zohlen said. "However, if you lose your job, it also depends on how marketable you are and how quickly you can replace your income."
Respect the economy and rising costs.
"I'd say you should stretch that emergency fund to nine months or even a year of living expenses, especially if you have reason to believe your job is shaky," advised Christine Benz, director of personal finance for Morningstar Inc. in Chicago. "Too often, the emergency fund isn't as large as it should be."
Next, look to existing longer-term taxable investments to obtain cash. Examine your personal portfolio to see which stocks, stock funds, bonds or bond funds can be sold. Despite tax liabilities and potential redemption fees, you're not borrowing anything you'll have to repay. It is your money.
If circumstances force you to take money from a retirement account, Benz considers a Roth IRA the best starting place because you've already paid taxes on that money. You can withdraw Roth IRA contributions (but not earnings) you've made at any time without penalties or tax.
Early withdrawal from a traditional IRA is less desirable because it requires you to pay taxes and you'll also incur a 10 percent penalty.
"If you've got cash value in a life insurance policy, this is a good time to take a loan on that," Zohlen said. "The last place to go is retirement savings and especially a traditional IRA."
As far as life insurance cash value is concerned, you can withdraw money and have it deducted from the face value, or you can take a non-tax-deductible loan from the cash value.
There are also loans from employee 401(k) retirement accounts, with some companies even providing debit cards. Just keep in mind that if you lose your job, you'll have to pay the loan back promptly. Zohlen cautions that borrowers often don't repay those loans and that many company plans require contributions be suspended if a loan has been taken out.
A much worse choice is actual withdrawal from a 401(k), which many companies permit only if you've used up other financing and there is urgent need. You'll pay tax on the withdrawal and a 10 percent early distribution penalty.
Another popular source for cash is the home equity line of credit, offering reasonable interest rates if your credit is good. The most attractive feature, of course, is that all or part of the interest is tax-deductible.
"Using home equity as an ATM has been a problem for many homeowners recently, and with declining property values, one of the risks is borrowing more than your home is worth," said Benz, noting that if you had to sell your home in a hurry you'd need to come up with the difference.
Benz noted other cash sources:
• A reverse mortgage, which allows senior citizens to receive assets that represent their equity in their homes. If they leave the home, the borrowed amount plus interest is deducted from the home value.
• A margin loan, which permits borrowing against the value of securities in your brokerage account. The value of securities can fluctuate, however, and you'll receive a margin call if they fall below a certain percentage.While the pros and cons of various alternatives for cash require more in-depth scrutiny than possible here, financial well-being in hard times merits a long hard look.
Andrew Leckey answers questions only through the column. Address inquiries to Andrew Leckey, P.O. Box 874702, Tempe, Ariz. 85287-4702, or by e-mail at [email protected]