In this report
Overview

Where to find emergency cash

Guidelines for tapping your assets without paying too much in penalties and taxes

Suppose you've followed our common-sense advice about saving money for a rainy day and have an easy-to-access emergency fund that can cover your expenses for three to six months. What if that rainy day turns out to be a deluge? A medical emergency, a family crisis, or a devastating flood, for example. Where will you get the money to cover the costs of those unexpected events?

You might have cash invested in a 401(k), bank certificates of deposit, stocks, bonds, or even an insurance policy. But cashing in those assets comes at a price in the form of taxes, penalties, or lost investment opportunities. So, if possible, try to handle large unexpected expenses without dipping into your portfolio.

"People should recognize that with very few exceptions, you can negotiate payment in an emergency," says Doug Thorburn, a financial planner in Van Nuys, Calif. In many cases, for example, doctors and hospitals will allow you to pay back a large debt, interest-free, over several years.

"Regrettably, I often tell my clients the first place to go is to borrow from their credit cards because they're not in the frame of mind to think clearly about what else to do immediately," says Rick Kahler, a fee-only financial planner in Rapid City, S.D. Credit-card interest is high, but it buys you up to 25 days of interest-free money during the initial billing cycle to figure out what the right approach to get the cash would be, Kahler says.

A better idea would be to have a strategy in place before a crisis hits so you're ready to respond immediately without taking on more debt. That plan might include the following steps:

1. Cash in CDs first

If you need to get your cash out of a CD before its maturity date, you'll probably pay an early-withdrawal penalty, the amount of which can vary widely among financial institutions. Many banks charge about six months' interest for taking your money out of a one-year CD early. But with interest rates low now, you might not give up too much if you have to pay such a penalty.

2. Sell bonds, then stocks

Bonds are among the simplest and least-expensive investments to part with because—assuming interest rates have not fluctuated wildly since you bought them—you shouldn't have much in the way of capital gains (or losses) to worry about. As a result, the tax consequences of the sale are usually minimal.

To make sure that selling your bonds will not affect your asset allocation too drastically or for too long, financial advisers recommend that you treat it as a loan to yourself to be paid back over a period of, say, two years at half or more of the bond's interest rate. "If you put this money each month into a no-load bond fund, the fund's dividends and interest distributions will cover the rest of the interest that you are not paying back to yourself," Kahler says. "Within a short period of time, your portfolio will be whole again and your asset mix back in balance."

Stock sales are a bit more complex, but you can derive some tax benefits from selling stocks while you raise the cash to meet your needs. If you're holding shares that are worth less than you paid for them, you can sell them and claim a tax deduction for your losses. Joint filers can write off an unlimited amount of losses to offset their capital gains on other investments, and they can apply an additional $3,000 a year in losses to offset regular income. Any remaining losses can be carried forward to offset gains or income in future years.

Also consider selling equity mutual funds that are flat, losing money, or generating below-market returns, especially those that are likely to make high capital-gains distributions in late November or December. Those distributions represent the earnings from individual sales of profitable investments that active fund managers made throughout the year. You want to sell the funds before the distribution is made because the fund's share price will drop by the distribution amount and you'll owe taxes on it.

Sell the fund before the distribution date at the higher share price, and use the proceeds from the sale to cover your emergency and, if applicable, take a tax deduction on your loss. If you still like the fund's long-term prospects, you can buy it back after the year-end capital-gains distribution. Just be sure you wait at least 31 days before you repurchase the shares or the Internal Revenue Service will disallow the loss under its "wash-sale" rules.

3. Look to your life-insurance policy

If you have an insurance policy that includes a savings or investment component, such as whole or universal life, its cash value grows with each premium you pay. (A term life-insurance policy is less expensive to purchase but has no cash value, just a death benefit.) After a few years, most insurers will allow you to borrow up to 95 percent of the policy's cash value at reasonable interest rates, with no tax due on the proceeds. Because you are borrowing against your own policy, the loan needn't be paid back, although if the interest isn't covered, the insurer will take it out of the money left in your account. And if the debt exceeds the value of the policy minus the loan, it could be called in. Then you might have to pay income taxes on at least a portion of the loan.

In general, though, borrowing against a policy with cash value is a relatively economical solution in an emergency. It's important to remember, though, that the money you take from your policy won't be there for your heirs when you die.

But if a long-held life-insurance policy is no longer a necessary part of your financial plan—perhaps your estate expenses can be covered by other assets and your heirs are no longer financially dependent on your income—it might make more sense to cash it out. You'll owe income tax on any amount above what you paid in premiums. But because most cash-value policies are front-loaded with fees, you would likely need to hold one for upward of 15 years before the cash value exceeded the premiums you paid.

Some companies offer to buy policies for amounts substantially greater than the cash value of the policy. In so-called life settlements, the buying company becomes the beneficiary on the policy, continues to pay the premiums, and makes its profit when you die.

There are no significant risks involved in such a transaction conducted with a legitimate company, particularly if you were going to cash in the policy anyway. But some people find it uncomfortable to think that a company they've barely heard of stands to benefit from their death. And you might get tagged with a high tax bill on the amount of the disbursement above the policy's cash value.

4. Tap your retirement fund as a last resort

Many employers allow 401(k) plan participants to withdraw money from those programs before age 59½only in certain "hardship" situations, such as to pay medical expenses, to avoid eviction or foreclosure, or to cover college tuition or funeral expenses for a close relative.

But hardship or not, the IRS imposes a 10 percent penalty on early 401(k) withdrawals on top of the income tax that you have to pay on the distribution. So if you're in the 33 percent tax bracket, a $10,000 withdrawal from your 401(k) could cost you more than $4,000. And that's not counting the $50,000 or so in compound interest that you would probably earn by leaving that money in retirement savings for the next 20 years.

Generally, the rules for a traditional IRA are similar to those governing 401(k) plans except that the 10 percent early-withdrawal penalty is waived if the money is needed because of a hardship. And you can take as much as $10,000 out of your IRA penalty-free once in your lifetime to cover a down payment on your first home. However, given the tax implications and loss of retirement savings, tapping an IRA early isn't a good idea. A Roth IRA is easier to dip into as long as it has been funded for at least five years. You can withdraw money in emergencies or for a first-time home purchase tax- and penalty-free.

Borrowing against your 401(k) plan, if allowed by your employer, is another option. A bit more palatable than a straight withdrawal, it is nonetheless frowned on by many financial experts. Usually, the loans are limited to $50,000 or 50 percent of your vested balance, and they must be repaid within five years at an interest rate about a point above prime. Those are pretty good terms, and you're essentially paying yourself back, so the interest is actually going back into your own portfolio.

The downside, though, is significant. If you lose your job or leave voluntarily, you have to pay the loan back in full or be in default, in which case you would owe income tax and the 10 percent penalty on the unpaid amount. That's an expense you don't need when you are trying to deal with an unexpected crisis.

Moreover, by reducing your 401(k), even temporarily, you will have less money quietly compounding for your retirement. And while you'll be paying yourself interest, it will probably fall short of what you'd have earned had the loan money remained in the 401(k). "A $50,000 loan in your 40s could set your retirement savings back by as much as two years," Thorburn says.

This article appeared in Consumer Reports Money Adviser.

Posted: November 2008 — Consumer Reports Money Adviser issue: Last reviewed: July 2009