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Investing Specialists

Where to Turn for Emergency Cash, Part II

More ideas on where to go in times of financial crisis.

With the headlines screaming fresh news about job losses and ongoing housing-market woes, I guess I shouldn't have been surprised that my column about where to go for emergency cash prompted a large response from readers. Many of you wrote with comments and questions, and others pitched in with additional ideas that I hadn't covered in my article.

Because the topic of where to turn for emergency funds is a broad one, I'll use this article to address some of the points that I didn't cover last week.

The Right Investments for Your Emergency Fund
In my previous column, I noted that the best source of cash for unanticipated financial needs is your own emergency fund. That prompted several readers to ask where they should keep their cash.

Because you won't know in advance when you'll need to tap your emergency-fund assets, you need to invest in securities that will ensure a steady principal value: CDs or a money market account or fund. You can also count other liquid assets--such as the amounts that you hold in your savings and checking accounts--toward your emergency fund, as long as you're not committing these assets toward other uses.

I know, the emergency fund isn't a small pool of assets, so it's tempting to want to reach for a higher yield by venturing into an ultra-short-term or even a short-term bond fund. I'd urge caution on this front, however. Some funds that investors may have considered just a step up from a money market vehicle posted extreme losses amid the subprime crisis, with  Schwab YieldPlus  the poster child for just how bad things can get. (The fund has lost a shocking 39% of its value over the past year.) While an implosion of that magnitude is unusual, you can't count on a stable net asset value with ultra-short- and short-term bond funds, and the funds delivering the most tempting yields may also be taking on outsized risks to deliver their payouts.

My advice is for everyone to keep a minimum of three to six months' worth of living expenses in CDs and money market accounts or funds. If you decide that your emergency fund should be larger--either because your employment picture is unstable or you have a high income that could be tough to replace in case of job loss--it's probably OK to put those additional assets in something with a little more yield potential. In this vein, a couple of my favorites include  Vanguard Short-Term Tax-Exempt (VWSTX) and  Vanguard Short-Term Investment-Grade (VFSTX). (By all means, opt for municipal securities for your emergency fund if you'll earn a higher aftertax payout.) For some dos and don'ts about where to park your short-term cash, read this article.

Life-Insurance Cash Values
One other source of emergency cash that I neglected to mention in my initial article is the cash value that you've built up in your whole life insurance or variable universal life insurance policy.

You can withdraw money outright and have it deducted from your policy's face value--for example, if you withdrew $15,000 from a policy with a cash value of $50,000, your heirs would receive $35,000 when you die. Alternatively, you can borrow from the cash value of your life insurance. You'll owe interest on the loan, payable to the insurance company. These rates can be reasonable but aren't always low, so it pays to check with your insurance agent to determine whether a loan is competitive with other sources of emergency funding. Also, be mindful that life insurance loans may come with hidden costs--for example, the insurer may reduce the dividends being paid into your policy for as long as you have the loan.

If you take a loan from your insurance policy's cash value, you will not owe taxes but nor is the interest you pay tax-deductible, as is the case with interest on a home-equity line of credit. Moreover, outright withdrawals from the cash value of your life-insurance policy won't be tax-free if you take out more than you put into it in the first place.

Margin Loans
A margin account allows you to borrow against the value of the securities in your brokerage account. Margin accounts are used most frequently by traders who want to buy more securities, but the money you extract from your margin account can be used for anything.

This option would be most attractive for those who have assets but don't want to sell them because that would mean unloading them at a bad time and/or incurring tax consequences. If you expect to be able to repay the money in short order and are trying to decide between taking a margin loan or selling securities to raise cash, the margin loan could be the better bet.

On the downside, interest rates can be reasonable, but they aren't always attractive relative to other sources of financing, such as home equity lines of credit. The bigger knock against margin loans--particularly for someone who's in a sketchy financial situation to begin with--is that they're risky. The reason is that the securities in your account serve as your collateral, and the securities' value can fluctuate with the market. If your collateral drops below a certain level due to market declines, you're going to receive a "margin call." Essentially, that means your brokerage firm will require you to deposit more money or sell the securities to bring your collateral amount up to a certain percentage. If you don't have the cash at the ready, you can end up in an even bigger financial bind than you started with.

Intrafamily Loans
I know, borrowing from--and loaning to--family members is a potential minefield, and I'll leave it to each of you to decide whether engaging in such transactions with family members is an appropriate option. Nonetheless, obtaining a loan from a family member may be a viable alternative to borrowing from an outside source at a high rate of interest or tapping capital that would entail big penalties and/or tax costs. 

It makes sense for both parties of an intrafamily loan to enter into the transaction as a legally binding one with all the trappings of a regular loan, including an interest rate in line with prevailing rates and full documentation. If you choose to make a loan without a formal arrangement in place, make sure you're loaning money you can afford to lose.

If you're the lender in an intrafamily loan and plan to charge interest on that loan, you're required to list any interest you receive as income on your tax return. And if you end up making a gift, rather than a loan, to a cash-strapped relative, you owe it to yourself to understand the rules regarding gift tax. In 2009, you can give up to $13,000 to an unlimited number of individuals without triggering gift tax. Be sure to indicate on your check that the amount is a gift rather than a loan.

Time Horizon Matters
One reader made a particularly good point in response to my previous column: Time horizon is a crucial consideration in deciding which of these options is best for you. If your time horizon for the emergency money is very short, an otherwise undesirable source of emergency funding may be more attractive than it appears at first blush. For example, say you need cash to pay a bill that's due right now but you're set to receive a big inheritance in two weeks. Rather than going to the bother of tapping an asset like a 401(k) or IRA--and potentially triggering attendant penalties and taxes--you may be better off using a credit card to cover the bill because you'll be able to pay it off without owing interest. Before you go this route, however, you need to make sure that your source of future funding is rock-solid.

Prolonging the Inevitable?
I should have noted this in my previous column, because it's an excellent point raised by a reader: If a financial emergency sends you scurrying for cash, take a moment to consider whether you're merely staving off the inevitable by scaring up assets. If you find yourself in a financial predicament that your income and assets cannot support--for example, if your mortgage is apt to be unaffordable over the loan haul--face up to that reality as soon as possible rather than extracting money from other assets and potentially incurring tax, transaction, and interest costs along the way.  

 

 

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