The coronavirus pandemic not only triggered a worldwide search for face masks and vaccines, it also sent people scrambling to shore up their finances. Even before the crisis hit, the Federal Reserve found that 60% of US households couldn’t quickly gather enough cash to cover three months of living expenses. That became an even greater challenge amid a shutdown of the economy, millions of job cuts and the stock market crash. But there are various steps you can take to bolster your cash cushion while limiting damage to your long-term financial plans…
Strategy #1: Reduce your contributions to long-term savings, including 401(k)s, IRAs and/or 529 college savings plans. Although this could leave you in a weaker financial position when you retire or your children attend college, you may be able to make up for the reduction later in the year or next year. How to do this…
Consider cutting contributions to 529 education savings plans first. Your children or grandchildren can help pay for college by taking out federal loans and/or going to less expensive schools. However, when deciding whether to reduce your 529 contributions, keep in mind that in many states you can take a state tax deduction for at least part of your contribution to that state’s 529 plan.
Weigh various factors when deciding whether to cut contributions to Roth accounts versus traditional retirement accounts. Keep in mind that, unlike with a traditional 401(k) or IRA, you don’t get a tax deduction on Roth contributions that you make…and if you are in a cash crunch, you may need those deductions to lower your tax burden. However, also consider that in the long run, Roth contributions may make sense for some people because future tax rates may be higher than current tax rates. That benefits a Roth account because, unlike with traditional retirement accounts, the money in a Roth account is not taxed when you eventually withdraw it.
Cut your 401(k) “match” amount last. Many companies match a certain percentage of what an employee contributes to a 401(k), typically 50% of every dollar up to 6% of salary. Maximize getting this free money.
Strategy #2: Withdraw from existing taxable investments. This allows your retirement account investments to continue to benefit from tax-advantaged growth. However, you must choose which investments to sell strategically or else you could lock in steep losses and/or face a big tax bill on investment gains. How to do this…
You can gain access to more cash by suspending automatic reinvestment of dividends generated from stocks and funds…and capital gains from funds. Keep in mind that you must pay tax on this income whether you reinvest or not.
If you need more emergency cash, sell bonds or bond funds that have appreciated. This allows your hard-hit stocks and stock funds time to recover.
Sell stocks and stock funds last. Use this litmus test for each holding: At the current price, would you be willing to buy and hold it as a long-term investment? If not, it becomes a candidate for sale. Keep in mind that if you sell a stock whose current market value is below its cost basis, you may be able to take a capital loss to offset gains from profitable investment sales, as well as up to $3,000 in income, this year or in the future.
Strategy #3: Borrow against your taxable investments. Many brokerage firms offer an investment line of credit, allowing you to borrow up to 40% to 80% of the current value of your taxable portfolio assets, which serve as collateral for the loan. You pay a variable interest rate, recently ranging from 3% to 5.25%. Downside: If financial markets fall and lower the value of your pledged assets, you may get a “maintenance call” in which your brokerage firm requires that you post additional collateral or pay down part of your outstanding balance.
What to do: Be sure your broker explains how large a decline might trigger a call. Each firm has proprietary standards based on the type and amount of assets pledged and your loan balance.
Strategy #4: Take Social Security earlier than planned. You can claim benefits as early as age 62 and start receiving a guaranteed monthly stream of income for the rest of your life. However, the amount of the monthly payments will be significantly lower than if you wait until full retirement age—66 to 67 depending on when you were born—or until 70, the longest the eventual amounts will keep rising. For every year you delay, eventual payments increase by about 8%. Helpful twist: There are ways to access some Social Security income early and still get higher benefits later on. How to do this…
If you’re between 62 and full retirement age, start taking benefits—then withdraw your claim within 12 months. As long as you repay the total amount of benefits you received, Social Security will treat your claim as if it never happened. This is effective if you just need cash for a few months to tide you over and you don’t expect your total monthly earned income in 2020 to exceed $1,520—otherwise your benefits are reduced by one dollar for each two dollars over this amount.
If you already have reached full retirement age, take benefits as long as you need the money, then suspend them. You don’t have to pay any cash back, and for every month you suspend payments, up to age 70, you earn delayed retirement credits, which will ultimately result in a higher monthly benefit payment amount. Example: If your full retirement age is 66 and you start taking payments at that time, then suspend them at age 67 and delay resuming benefits for three years. The payments you get each month starting at age 70 will be about 24% higher than those at 67.
Strategy #5: Tap the equity in your home. Use your home as collateral to get a new loan with a relatively attractive interest rate. Your loan and rate are contingent on factors such as your credit score, your income and the amount of equity in your home, which is the difference between the current value of your home and what you owe on your existing mortgage. Keep in mind that if you default, your lender could foreclose on your home. How to do this…
Do a cash-out refinance. It allows you to refinance your mortgage at today’s low interest rates and borrow extra money. Keep in mind that although your monthly payments may be lower, the balance you owe on the new mortgage will be the same as the old one plus any additional money you borrow. Recent rates averaged 3.1% for a 15-year refinance and 3.8% for a 30-year refi.
Get a home-equity line of credit (HELOC). This is best for people who don’t need the money immediately but may need it soon. You draw only on the money you need when you need it. Interest rates on HELOCs are variable and recently averaged 4.5%. Closing costs often are minimal.
Avoid home-equity loans. If the value of your home declines, which is not unusual in a recession, you could owe more than the home is worth. Closing costs can be as high as a refinance, but the rates are not as low.
Avoid reverse mortgages—the entire loan may become due shortly after you move out of the home for more than a year, sell it, pass away or become delinquent on your property taxes and/or insurance.
Strategy #6: Withdraw cash from your retirement accounts. I rarely recommend digging into these accounts because the long-term tax-advantaged growth they offer is so valuable. However, the CARES Act allows you to take distributions and loans with fewer restrictions and penalties than usual if you’ve suffered financial or health consequences because of COVID-19. How to do this…
Take a hardship withdrawal. If you are under age 59½, you now can remove a total of $100,000, instead of $50,000, across all retirement accounts—such as 401(k)s and traditional IRAs, both traditional and Roth—until the end of 2020 without a 10% penalty if you have been affected by the coronavirus pandemic. Any income resulting from the distribution can be spread evenly over a three-year period for tax purposes. Or you can pay back the money to your retirement accounts within three years and owe no taxes at all.
Take a 401(k) loan. The new law doubles the amount a 401(k) holder may take tax-free to as much as $100,000 or 100% of the account balance, whichever is lower. The higher-limit loans could be taken only up to a deadline that was initially set at September 23, 2020.
Participants can delay any repayment for a year and then have five years to repay the amount borrowed plus interest. Otherwise, it’s treated as a taxable distribution. Typical rates recently ranged from 5.25% to 6.25%. I prefer loans to hardship withdrawals. Reason: More time to pay back the money if you need that flexibility. Also, the interest you pay goes back into your 401(k) account.
Important: The money you repay on loans and hardship withdrawals does not count toward the annual contribution caps for retirement accounts. Also, check to make sure your company actually offers these new loan and hardship options since it is not obligated to do so.