Every household should strive to keep an emergency fund that is big enough to cover expenses for at least six months, especially in these tricky times. But if that money runs out, you need to know where to turn first to raise cash while avoiding penalties and/or taxes on that money. The best order…
- Sell stuff that you don’t want or need. Many people have valuable items in their homes that they can turn into cash. The easiest way is to advertise on the classified ad Web site Craigslist.org — listings are free.
- Redeem long-term certificates of deposit (CDs). Many banks impose a penalty of six months in interest for early withdrawal on a one-year CD, but with interest rates as low as they have been lately— typically just 2% — that’s not much of a penalty.
- Stop reinvesting interest and dividends that you earn on your savings and investments. This is a relatively painless way to restock your emergency fund, although it could deprive you of the opportunity to buy more shares of stock or bonds cheaply.
- Borrow from a relative or friend. Tread lightly here, because an unpaid debt can poison a treasured relationship. Have an attorney draw up a promissory note spelling out the terms of the loan, including an agreed-upon interest rate. Such rates are usually based on the “applicable federal rate,” published monthly by the IRS. In April, the rate ranged from 0.83% a year for loans of less than three years to about 3.67% a year for loans longer than nine years.
- Borrow against home equity. Many banks and credit unions continue to provide home equity lines of credit (HELOCs). However, you may now need 20% or more equity in your home and a FICO credit score of 660 or better (out of 850) to qualify… and to merit the lowest interest rates, you may need a stellar score of 750 or higher. If you meet these criteria, you may be able to borrow at initial rates as low as 3.25%, making HELOCs some of the cheapest money around. They carry no closing costs and low up-front charges (about $400), though you may pay an additional annual fee of about $50 to maintain the line.
- Sell stocks. If your shares have lost value since you bought them, you can use the capital loss now or in a later year to offset capital gains and up to $3,000 of ordinary income and thus reduce your taxes. You can also consider selling bonds now, but one result of the credit crisis is that the market for individual bonds is highly illiquid, meaning that there are few buyers out there for individual bonds. Even if you find a buyer, you’ll probably wind up selling at a discount.
- Borrow from life insurance. Many whole-life policies allow you to borrow up to 90% of the cash value at favorable interest rates, and such borrowed amounts are tax free.
- Caution: If you die before repaying, the death benefit to your beneficiaries is reduced by the amount of the loan plus interest owed.
- Consider tapping your IRA. Uncle Sam imposes a 10% penalty on IRA assets withdrawn before age 59½, on top of ordinary income taxes. But under the IRS’s 72(t) rule, you may take “substantially equal periodic payments” penalty free before age 59½, provided they run a minimum of five years. You may also take an early distribution if you are unemployed and use the money to pay health insurance premiums and in several other circumstances. You may withdraw IRA contributions made for the year if the contributions, plus earnings, are withdrawn by the due date of your return (including extensions). Roth IRA contributions can be withdrawn at any time (they were made with after-tax money). Earnings on Roth IRA contributions can be withdrawn free of taxes and penalties only after age 59½, on account of disability, or for first-time home buying, provided that the account has been established for at least five years.
Helpful: If you can pay yourself back within 60 days, you may borrow from a traditional IRA for any reason without paying taxes or penalties.
More information: See IRS Publication 590, Individual Retirement Arrangements (IRAs), at www.irs.gov.
Turn to a 401(k) plan as a last resort. The strictest rules apply to withdrawals from 401(k)s. You pay income tax and a 10% penalty even for hardship withdrawals — generally, similar situations to those described in the IRA section above.
Exception: If you retire or lose your job at age 55 or later, you may begin taking distributions penalty free.
Another option is borrowing from your 401(k). Loans are usually limited to 50% of your vested balance up to a limit of $50,000, and you must repay them within five years. But interest rates are low — generally just a percentage point or two above the prime rate. If you lose your job, you must repay the loan, usually within 30 or 60 days, or be taxed on the unpaid balance, as well as pay a 10% penalty if you are under age 59½.
