When unexpected expenses surpass your emergency reserves, you have several options. Here is a ranking from the most to least palatable sources of cash, based on advice from Morningstar's Christine Benz.
1. Your Own Emergency Fund or Short-Term Securities
Emergency funds should be held outside tax-sheltered accounts in highly liquid investments such as bank savings accounts, money market accounts, and similar instruments. For those who are employed, an emergency fund should ideally cover three to six months of living expenses. Retirees should target one to two years' worth of anticipated portfolio withdrawals.
2. Low-Risk Assets in Taxable Accounts
The next source of cash is other taxable holdings, such as investments in brokerage accounts that are not within tax-sheltered vehicles. When identifying securities to sell, consider liquidity, tax consequences, and transaction fees. Ideally, you would sell a short- or intermediate-term bond fund, which is reasonably liquid and typically has already incurred taxes on most gains.
3. Roth IRA Contributions
You can withdraw any Roth IRA contributions (the amount you put in, not investment earnings) at any time without penalties or taxes. The major drawback is that you will have fewer retirement funds working for you.
4. Life Insurance Cash Values
You can withdraw money outright from a whole life insurance or variable universal life insurance policy, which is then deducted from the face value. These withdrawals are tax-free as long as they do not exceed the amount you have contributed. A less attractive option is to borrow from the cash value, which incurs interest payable to the insurance company and may come with additional costs. While no taxes are owed, the interest is not tax-deductible.
5. 401(k) Loan
Even though you pay interest on a 401(k) loan, it is repaid into your account, and interest rates can be reasonable. However, this reduces your retirement savings. If you lose your job, you must repay the loan within 90 days; otherwise, you owe taxes and a 10% penalty, unless you are 59½ or older.
6. Home Equity Line of Credit (HELOC)
Interest rates for borrowing against home equity are usually reasonable, especially with good credit. However, if you are not a perfect borrower, you may be denied or receive an unfavorable rate. Borrowing more than your equity could force you to cover the difference if you sell quickly. Additionally, HELOC interest is no longer tax-deductible unless used for home improvements.
7. Hardship Withdrawals
Funds taken from a 401(k) via hardship withdrawal cannot be repaid, and you owe taxes on any untaxed dollars withdrawn. You also incur a 10% penalty unless you are 59½ or older or meet specific exceptions. Taxes can significantly reduce the amount you receive.
8. Reverse Mortgage
Reverse mortgages allow homeowners aged 62 or older to access a pool of assets representing home equity. No repayment is required while living in the home, but upon leaving, the borrowed amount plus interest is deducted from the home's value. Rates vary widely, and these loans can be costly and complicated, so careful comparison and reading of terms are essential.
9. Margin Loans
A margin account lets you borrow against the value of securities in your brokerage account. This may be useful if you want to avoid selling assets at a bad time or incurring tax consequences. However, interest rates are often unattractive, and margin loans are risky because securities values can fluctuate. If collateral drops below a certain level, the brokerage may require additional deposits or forced sales, potentially worsening your financial situation.
10. Credit Cards
Some consumers can manage credit cards by shifting balances among cards with low teaser rates, minimizing interest. For most people, however, credit cards are the easiest way to damage financial standing. High interest rates and minimum payments that barely reduce principal make them a poor emergency funding source.
