The current pandemic isn’t just a health crisis. For many households it’s a financial crisis as well. Unemployment claims and healthcare costs are spiking, and while the stimulus may help, many individuals will struggle to pay their bills. They’ll need to get their hands on some cash.
The CARES Act provides for direct cash payments to many taxpayers, including Social Security recipients.
To help further aid citizens who are in a financial crunch, the stimulus package will also make it less painful for investors in IRAs or company retirement plans who have been affected by the coronavirus to get access to their money. Specifically, the legislation removes the 10% penalty that normally applies to hardship withdrawals from company retirement plans and IRAs, up to $100,000, for affected individuals. It also gives individuals who have taken a hardship withdrawal due to COVID 19-related issues the option to pay the funds back over three years and to split the income associated with the withdrawal – and the associated tax burden – over three years as well. (Withdrawals of up to $100,000 from 401(k)s and IRAs skirt the 10% penalty but not the ordinary income taxes that are due on any withdrawal of tax-deferred assets.) Additionally, it boosts the allowable loan amount from employer-sponsored retirement plans to $100,000 from $50,000 for people who have been affected by the coronavirus.
With these developments in mind, let’s survey the options for consumers who need additional funds. Although individuals’ own circumstances will affect the attractiveness of these sources of financing, I’ve attempted to rank them from the ones that are generally the most palatable (fewest restrictions and costs, least disruption to long-term plan) to the least attractive (highest costs, most onerous taxation).
1. Your Own Emergency Fund/Short-Term Securities
The starting point for anyone in search of emergency cash should be the obvious: an emergency fund, specifically earmarked for times like these. Because emergency funds are meant to offer ready access to cash, they should be held outside of tax-sheltered wrappers and include highly liquid investments like bank savings accounts and/or money market accounts. If you’re working, your emergency fund would ideally hold a minimum of three to six months’ worth of living expenses; retirees should target one to two years’ worth of anticipated portfolio withdrawals.
2. Low-Risk Assets in Taxable Account
Assuming you’ve depleted your emergency fund and you still need cash, your next step should be to take a look at other taxable holdings that you have: investments in brokerage accounts, outside the confines of tax-sheltered vehicles. When identifying possible securities that you could sell to raise funds, focus on a few key things, such as liquidity and any tax consequences you’ll owe to sell.
In a best-case scenario, you’d have a short- or intermediate-term bond fund that you could sell. It’s reasonably liquid, if not quite like cash, and you’d already have paid taxes on most of your gains, in that income distributions are taxed as you receive them. But liquidating longer-term investments could make sense, too, especially if you’ve recently purchased them and could take a tax loss or you expect to be in a low tax bracket this year, meaning that any gains would be taxed at a low rate.
3. Life Insurance Cash Values
Cash values that have built up in your whole life insurance or variable universal life insurance policy can be another decent source of emergency cash. 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. Those withdrawals are tax-free, assuming they don’t exceed your cost basis (that is, the amount you’ve put into the policy).
Another possibility, albeit a less attractive one, is to 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 additional 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 the interest you pay is not tax-deductible.
4. Home Equity Line of Credit
Tapping your own assets is invariably a better source of cash than borrowing from someone else. But if you find that you must take out a loan, using a home equity line of credit is one of the better ways to go about it. Essentially, you’re borrowing against any equity you’ve built up in your house.
On the plus side, interest rates on HELOCs may be reasonable, particularly if you maintain a good credit rating, have a fair amount of equity in your home (which also makes it less likely that you’ll default), and aren’t taking out a huge loan.
On the downside, if you’re not a perfect borrower, you could be asked to pay an unfavorably high-interest rate or be denied the line of credit altogether. And if you end up borrowing more than you actually have equity in the house, should you need to sell in a hurry, you’d have to cough up the difference. (We saw this problem in stark relief during the global financial crisis.) Finally, the interest on HELOCs is no longer tax-deductible unless the funds are used for home improvements, and in any case, many taxpayers benefit more from claiming the standard deduction than they do with itemized deductions.
5. Roth IRA Contributions
As noted above, the CARES Act includes provisions that make it easier for people affected by the virus to tap into IRAs and company retirement plans. But I’d still put withdrawals of Roth IRA contributions higher in the emergency-funding queue than hardship withdrawals or loans from IRAs or 401(k)s.
Of course, it’s never a great idea to tap your retirement assets unless you absolutely need to, but the Roth IRA offers more flexibility and has fewer strings attached than other tax-sheltered retirement vehicles. Specifically, you can withdraw any Roth IRA contributions (the amount you put in, not investment earnings) at any time, without having to pay penalties or tax. The big downside, of course, is that you’ll have fewer retirement funds working for you. Moreover, if your contributions are invested in stocks, you’ll be pulling the money out after stocks have incurred sizable losses.
6. 401(k) Loan
As noted earlier, the CARES Act allows for larger 401(k) loans, up to $100,000 from $50,000, subject to the plan sponsor’s discretion, for people who need the funds due to coronavirus-related issues. The 401(k) loan is better than a hardship withdrawal (discussed below) because even though you’re required to pay interest on the loan, the interest gets paid back into your account. And the interest rates can be reasonable, often a few percentage points above the prime rate.
On the downside, borrowing from your 401(k) plan pulls from your retirement savings. Not only will you have less money working for you in the market, but having to pay the loan back with interest also means you’re less likely to be able to make new contributions to your account. Loans from your 401(k) are particularly perilous if you lose your job. If that happens, you’ll be required to pay the loan back right away, usually in 90 days. If you can’t, you’ll owe taxes and a 10% penalty, unless you’re age 59 and a half or older.
7. Hardship Withdrawals
As noted above, the CARES Act makes it easier for people who have suffered COVID-19-related harm to tap their IRAs and company retirement plans. Not only does it eliminate the 10% early withdrawal penalty for people affected by the disease, but it allows for the funds to be paid back over three years and the withdrawal-associated tax burden to be spread over three years as well.
The big downside is that stocks have tumbled in recent months, so it’s arguably a less-than-ideal time to be pulling from long-term assets. While you can pay the money back into the account, you may do so after stocks have already recovered.
8. Reverse Mortgage
A reverse mortgage allows older homeowners older than age 62 to receive a pool of assets that represents equity in their homes. The homeowners don’t have to repay the loan as long as they’re in their homes, but when they do leave, the borrowed amount, plus interest, is deducted from the home’s value.
As reverse mortgages have gotten more popular, they’ve prompted greater scrutiny and many more reputable lenders have gotten into the business. Still, rates can vary widely, so if such a loan appeals to you, you’ll need to shop around and read the fine print; the loans can be costly and complicated.
9. 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 (like right now) 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 aren’t always attractive relative to other sources of financing, such as HELOCs. The bigger knock against margin loans – particularly for someone who’s on shaky financial footing 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 because of 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.
10. Credit Cards
This option is pretty straightforward and usually not a great idea for reasons that most consumers well understand. True, some consumers have been able to play credit cards like a fiddle, shifting balances among cards with ultralow teaser rates and incurring little in interest along the way. If that’s you, more power to you. For the rest of the world, credit cards are the single easiest way to wreck your financial standing. Not only are rates high, but credit card companies have every incentive to keep you paying for as long as possible. Thus, the minimum payments they require don’t make a dent in your loan’s principal.
Paul Staib | Certified Financial Planner (CFP®), MBA, RICP®
Paul Staib, Certified Financial Planner (CFP®), RICP®, is an independent Flat Fee-Only financial planner. Staib Financial Planning, LLC provides comprehensive financial planning, retirement planning, and investment management services to help clients in all financial situations achieve their personal financial goals. Staib Financial Planning, LLC serves clients as a fiduciary and never earns a commission of any kind. Our offices are located in the south Denver metro area, enabling us to conveniently serve clients in Highlands Ranch, Littleton, Lone Tree, Aurora, Parker, Denver Tech Center, Centennial, Castle Pines and surrounding communities. We also offer our services virtually.
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