Dear Carrie,
I find myself in the unfortunate position of needing some cash in the midst of this horrible pandemic and the resulting market decline. I have a small emergency fund but that’s not enough. What’s the best way to generate additional cash?
—A Reader
Dear Reader,
First, congratulations on having a rainy day fund. Even if it’s not enough, simply having a savings account shows you’re planning ahead. Emergency savings are your first and best line of defense. But sometimes when it rains, it pours, and in really tough times, you can be left short of what you need. Let’s talk about some options.
Take stock of what you’ve got
Before you start pulling funds from any account, don’t forget that help may be on the way from the Federal government including direct payments of $1,200 to individuals ($2,400 to couples), plus an additional $500 per child, for individuals earning less than $75,000 ($150,000 for couples). If you still need cash after taking this one-time payment into account, take a moment or two to look at all of your accounts. Are you forgetting anything? You might be surprised at what you find. This is a little like checking under the cushions for loose change. Having a complete net worth statement and consolidating accounts can make this easier.
Then take a look at the different accounts you have set up for specific goals. Different accounts will have varying rules for withdrawals as well as different tax implications. With this big picture in mind, you’ll be better able to make the best decisions.
Start here
Checking, savings, and money market accounts are the best place to start for several reasons. First, you can withdraw money from checking accounts at any time, although money market and savings accounts may have a few more restrictions. (Typically you’re allowed six “convenience” or electronic/online transfers or debit card withdrawals per month.)
Second, since your money is in cash, you generally don’t have to worry about timing (although cashing in certain accounts like CDs before they mature could cause you to forfeit interest as a penalty). And finally, tax implications for these taxable accounts are very low.
Next consider brokerage accounts
Your next option might be other taxable accounts like a brokerage account. The big gotcha is that because your money is likely invested in stocks, bonds, mutual funds, and exchange traded funds, you may give up future gains or lock in losses by selling sooner than you had planned.
When you withdraw money from a brokerage account, you may need to pay tax on your gains. On the plus side, capital gains rates can be lower than the ordinary income tax rates you will pay on withdrawals from retirement accounts like a traditional IRA or 401(k). You may also be able to harvest losses to offset gains when selling and deduct up to $3,000 against your income.
Last on the list for withdrawals are retirement accounts
Retirement accounts are usually the last place you want to pull money from because once you withdraw funds, it may be very challenging to make up lost retirement savings and the tax consequences are typically the highest.
Additionally, if your money is invested, you may be looking at selling at a loss. (But unlike a brokerage account, you can’t use losses to offset gains.)
Tax-wise, withdrawals, or ‘distributions,’ from either a traditional 401(k) or a traditional IRA are high because they’re subject to ordinary income taxes plus a 10 percent penalty for those under age 59½.
However, in response to the COVID-19 crisis, Congress has decided to waive the penalty on withdrawals up to $100,000 for those individuals who are directly impacted. Those individuals will also be able to stretch the income tax bill over three years. Alternatively, they can roll the money back into a 401(k)-type plan or an IRA within three years, and skip the tax payments.
Roth IRAs are different. First, you can withdraw your contributions without any tax consequence at any time. Second, provided you’re over age 59½ and the Roth has been established for at least 5 years, you can withdraw all earnings income tax free. Roth accounts can be a great place to withdraw a large lump sum.
For more help on taxes and penalties when making a withdrawal from a retirement account, be sure to talk to your financial advisor and tax professional.
Borrowing may be an option
Another approach would be to borrow money to meet your short-term needs. This only makes sense if you are confident that you will be able to handle the payments; missing payments can damage your credit score, cost you more money, and spiral down from there. Let’s review your options.
- Borrowing against your home: Home Equity Line of Credit and Home Installment Loans—A home equity line of credit (HELOC) or home equity installment loan is basically taking a second mortgage on your home. Interest rates on these types of loans are generally low, but that’s because you’re borrowing against your home. Missing a payment could lead to foreclosure.
- Borrowing against yourself: Credit cards and personal loans—Charging your expenses on a credit card can be a convenient in the moment, but the high interest rates are potentially lethal if you need to carry a balance month to month. Personal loans can also have very high interest rates, especially if you have a low credit score.
- Borrowing from your retirement: 401(k) Loans—AsI mentioned above, I generally think of all retirement funds as sacred. That said, taking a short-term loan from your 401(k) may be a viable option, provided you are convinced that you’ll be able to pay the loan back in the near future. Just be certain to understand all the rules, how the payments affect your paycheck and the tax consequences if you lose your job or miss a payment. Defaulting on 401(k) loan payments can lead to taxes and penalties.
- Borrowing from non-traditional lenders: Pay day loans and pawnshops—Finally, using non-traditional lenders like payday or vehicle title loans or a pawnshop may be quick and easy but dangerous and costly. Avoid these borrowing options at all costs.
To have to come up with money quickly that you hadn’t planned for can be unsettling. But you may have more options than you think. Make sure to look at all of them and consider how your choice could affect other areas of your financial plan. If you’re strategic and careful, you’ll have the best chance to get through your crunch unharmed.
Originally published on https://www.schwab.com/