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Christine Benz: Let's get right into a question that has been coming up a lot these days, and it's about where people who have suffered an income disruption or maybe some sort of an income shortfall, maybe their hours have been cut, where they can turn for cash if they need it. The obvious answer to this question is that you should have an emergency fund that equals three to six months' worth of your living expenses. You should have that in nonretirement accounts, so you can tap it without penalties, and you should keep the money really liquid, meaning that you can access it without disrupting your long-term investments. The problem is three to six months' worth of living expenses is a heavy lift for a lot of people, and many people simply don't have that type of cash cushion lying around. So the question is: If your cash cushion is depleted, what's your next best source of cash?
We're going to talk through some of the options here today. One of the best sources of cash would be nonretirement accounts, so like a taxable brokerage account where you might also have some safe securities parked. Maybe you have a short-term bond fund, for example, in the best-case scenario. In that situation, you won't incur taxes or certainly not a big tax bill to tap those accounts. You won't have any penalties because it's not a retirement account. It's sort of a next best-case scenario if your emergency fund is depleted.
If you have long-term assets in a taxable brokerage account, so maybe you're a stock investor in a taxable brokerage account, you may have some options there in that if you've recently purchased securities, like within the past few months, it's a good bet that those securities have dropped in value since you bought them. Stocks are down, so you may be able to sell those recently purchased lots and realize a tax loss, and so you can also unlock cash that way. So a taxable brokerage account would be one place to look.
Not everyone has a taxable brokerage account, so some other options would include cash value on a whole life insurance policy. Here again, not everyone has a whole life insurance policy. Some people have term policies, so that may not be an option for you either.
Moving over to retirement accounts, generally speaking, you really want to exercise caution when it comes to tapping your retirement accounts prior to retirement. And the big reason there is that you are going to be taking away from assets that you'll probably need in retirement, so that's the main reason. But another key reason is that you'll often incur taxes and penalties to get into your retirement accounts prematurely.
Say you do need to access your retirement funds. Your first line of defense there should be Roth IRAs. And the reason is that Roth IRA contributions can be withdrawn without taxes or penalties at any time and for any reason. This is just the contribution piece of your Roth IRA. It doesn't pertain to any investment earnings, and there are extra strings attached to tapping those assets. But the contributions are generally pretty liquid, and it depends on what you have the money invested in. But that's usually your first source of retirement assets if it turns out that you need to access your retirement funds.
The CARES Act, which Congress passed into law at the end of March, loosens up the strictures on some other retirement accounts a little bit. So let's just talk through those and talk about what's changing.
We'll start with 401(k) loans because I think that's generally better than an outright withdrawal of 401(k) funds. So with the CARES Act, Congress authorized 401(k) plans to allow loans of up to a $100,000 or 100% of the participant's vested balance, whichever amount is less. So you can take a larger loan from a 401(k) than you could in the past, assuming your plan allows it. And the nice thing about 401(k) loans versus borrowing from a third party is that you have to pay the money back into your account and the interest that you pay gets paid back into the account, too. So it's generally preferable to paying that interest to a third party. The real knock against 401(k) loans is that if it turns out that you lose your job--and there's a lot of uncertainty around jobs right now--you lose your job, you usually have to pay the money back in very short order, so typically within six months of your job loss. So that's the big risk attached to 401(k) loans. But generally speaking, a 401(k) loan will be better than tapping your retirement funds outright.
Another change with the CARES Act is that you can circumvent the 10% penalty on IRA and 401(k) withdrawals. Usually there's a 10% penalty if you need to withdraw funds from your 401(k) or IRA prior to retirement. With the CARES Act, if you can prove that you have some COVID-19-related hardship, you can circumvent the 10% penalty. You will owe taxes on those withdrawals, though. The good news is that the CARES Act allows you to pay those taxes over a three-year period, and it actually allows you to pay the money back into your accounts, so the money isn't permanently removed. So it's definitely better to withdraw 401(k) or IRA funds than it was pre-CARES Act, but it's usually better to investigate a 401(k) loan or withdrawals of Roth IRA contributions prior to looking at a withdrawal.
I want to talk a little bit about some things that you should try to avoid doing if you find yourself in a short-term cash crunch. Credit cards are an obvious thing to avoid. We all know well the high interest rates that can be attached to credit cards. Margin loans are another type of financing to avoid if you possibly can. This is essentially taking a loan against the value of securities in a brokerage account. There are risks attached to doing that. It's generally not something you would want to put high up in the pile if you needed to identify additional sources of cash.