Where to Turn for Emergency Cash
We consider some options and explore the pros and cons of each.
A version of this article originally published in December 2017.
You have a tight budget. Every month, you need to cover your housing expenses. You have a grocery and wellness budget. You have your entertainment budget. You're also saving for retirement and paying for insurance. After taxes and payroll deductions, there isn't really isn't all that much wiggle room in your take-home pay.
So what do you do if you have a (costly) emergency? Here we go through some options and examine the pros and cons of each. Be sure to carefully consider the tax ramifications of each before you choose.
A taxable account can be a good hunting ground for emergency cash, particularly if the account could use a rebalance. Home in on holdings in your account that have appreciated beyond your planned allocation and which you've held for more than a year, as those gains would be subject to long-term capital gains rates. If you're in the 10% or 12% tax bracket, you pay no taxes on the gain. Those in higher tax brackets will pay 15% or 20% on long-term gains. (If you've held a security for less than a year, it is taxed at ordinary income tax rates.)
You can also sell holdings at a loss and not worry about paying taxes on the gains. Most people don't like to sell securities at a loss, but when you're strapped for cash it could be an option. In that case, you could carry forward $3,000 in losses to offset capital gains and taxable income in future years.
Because Roth IRAs are funded with aftertax dollars, the contributions you make to them can be withdrawn tax-free and penalty-free. Be careful that you don't withdraw the investment gains portion, however--if you tap into the earnings portion before you are 59 1/2, you will pay tax as well as a 10% penalty.
There are some instances where you can withdraw the earnings portion penalty and tax-free before age 59 1/2, however. For instance, if you have held the Roth IRA for more than five years and you use the withdrawal to pay for unreimbursed medical expenses or health insurance if you're unemployed. Other allowable uses include purchase of a first-time home or qualified education expenses. If you are younger than 59 1/2 and have held the account for fewer than five years, you can avoid the 10% penalty but you will still have to pay tax on the earnings portion of the withdrawal.
Be aware, though, that this route can lead to a big setback in your retirement savings plan. Because of the yearly contribution limits for Roth IRAs ($6,000 per year) and income level phase outs (starting at $124,000 for singles and $196,000 for married filers), it could be difficult to get the money back into the account once it is withdrawn. In other words, you permanently lose the ability to have it compound tax free, unlike a 401(k) loan, where the amount you borrow eventually goes back in.
As with a Roth IRA withdrawal, it's never a great idea to borrow money from a retirement account that is in accumulation mode if you can help it--even if you plan to pay the money back within a certain time frame, this is prime time that your money could be compounding and working for you in the market. For that reason--if you can manage it--try to keep up your contributions while you pay back your loan.
But most 401(k) plans make it pretty easy and straightforward to take a loan from your savings. You are required to pay the money back and you will agree to a monthly payment, which includes interest that you pay back to yourself. Be sure to check the interest rate on the loan. Many times the rates are close to the prime rate; just make sure it's reasonable.
Be aware that 401(k) loans can be a big problem in the event that you lose or leave your job; you will be required to pay the loan back right away, usually within 60 days. If you can't repay it, you're on the hook to pay a 10% penalty and income tax on the loan balance.
Another consideration (somewhat more esoteric) is the issue of double taxation of the loan interest. As discussed in this video, when you borrow the money from a 401(k) plan and pay yourself back the loan interest, the money that goes to pay the loan interest is not pretax, nor is it tax-deductible. Then, when you take distributions from the 401(k), you will pay taxes on the money you paid in as loan interest a second time.
If your company offers company stock in the form of restricted stock units or stock options, it might be a good idea to consider selling some. After all, many financial planning experts recommend that company stock take up only a small portion of your portfolio (or even none at all)--the idea being that as an employee, your financial livelihood is already exposed to the health of the company, so adding in a large company-stock stake compounds that risk.
Be aware that there are tax consequences for selling company stock, though. Restricted stock units usually grant according to a vesting schedule, meaning that you have to work for the company for a certain amount of time before you can exercise the options. For instance, say you're granted 4,000 restricted stock units. One year from the grant date, 25% of them, or 1,000 shares, vest. The next year, another 25% vest, and so on, until they are all vested after four years. At the time of vesting, the restricted stock units are considered deferred compensation and you're taxed on the value of the shares (and the company usually pays payroll tax). The company may offer a choice of ways to pay taxes at vesting, but commonly the company takes some stock back when the shares vest, which is a cashless way to pay the income taxes due. If you decide to hold the stock for a year or more, the appreciation above the basis will be taxed at preferential capital gains rates. (Appreciation above the basis for holding periods of less than a year are taxed at ordinary income tax rates.)
Nonqualified stock options are granted and usually vest according to a time schedule, and the grant itself is not a taxable event. Rather, when you exercise the grant, which means that you opt to purchase the shares at the grant price, you pay income tax on the difference between the exercise price and the market price. For instance, say you were granted 100 shares of stock at an exercise price of $50. The shares are currently trading at a price of $75. You will owe tax on the difference between the market value and the exercise price, $25, times the number of shares (100), for a total of $2,500. This is taxed at ordinary income rates and is also subject to payroll tax. If you hold the company stock for more than a year and accrue additional gains above the $25 spread, you will owe long-term capital gains on the sale of the shares. (Again, ordinary income tax rates apply to holding periods of less than a year.)
Home Equity Line of Credit
Tapping into your home equity is another way you could come up with money in a pinch. Though you're paying interest to someone else, you're using your own assets by borrowing against any equity you've built up in your house.
There are a few reasons home equity lines of credit have been popular in recent years. First off, interest rates tend to be reasonable, especially if you have a good credit rating and aren't taking out a large percentage of your home equity. But a big advantage to the home equity lines of credit versus other loans is that all or part of your interest used to be tax-deductible--up to $100,000--which made for interest-free or at least interest-advantaged loan financing. Under the new tax plan, however, this interest is no longer tax-deductible, which puts these loans at a disadvantage to 401(k) loans as a source of emergency funding, says director of personal finance Christine Benz.
Traditional IRAs aren't as flexible as Roth IRAs in terms of early withdrawals. In most instances, you'll owe taxes and/or a 10% penalty if you need to take an early withdrawal from a traditional IRA if you've made deductible contributions.
Credit cards offer great convenience. Not only do they save you from lugging around a big wad of cash, they offer a grace period where you don't accrue interest on purchases so you can defer payment until the next billing cycle.
But carrying a balance can be a slippery slope. The average credit card charges an annual percentage rate upward of 16%, according to Bankrate.com. Paying off only the minimum balance is not a smart strategy. Check out this calculator from Bankrate.com; it computes how long it will take to pay off credit card balances at different interest rates and payment amounts. Let's assume you have a $5,000 balance, and you pay a minimum payment every month--say, 4% of your balance. At a 16% interest rate, it's going to take 10 years and six months to pay that off--and when all is said and done you will have paid nearly $7,400--a nearly 50% premium.
Take Action in Advance
In an ideal situation, you would be able to draw on your emergency fund. Many financial planners recommend setting aside anywhere from three to six months' worth of living expenses in very safe investments, such as cash or cash equivalents.
For those trying to stay afloat amid many financial obligations, this seems like a big ask. It might help to think of it this way: The only living expenses you need to cover with your emergency fund are the very basic ones--housing, insurance, utilities, and food. From that standpoint, amassing a cash cushion looks a lot more manageable, says Benz. She gives some advice for setting up and investing an emergency fund in this article.