Today, many people find themselves in a financial emergency as a result of the COVID-19 pandemic’s impact on our economy. Here, we’ve outlined four practical ways to respond to a financial emergency during these unprecedented times.
What constitutes a financial emergency?
Real financial emergencies are those rare times when a circumstance shifts our financial focus from the long term to the immediate future. During a financial emergency, we concentrate our efforts on getting through the challenge, while attempting to minimize the impact on our long-term plan and accepting that some adjustments may be required once the emergency is relieved in order to accomplish our long-term goals.
If you currently find yourself in this situation, financial discipline, with the help of historically-low interest rates and assistance from Congress through the Coronavirus Aid, Relief and Economic Security (CARES) Act, can guide you through. Consider the following:
1. Use your emergency cash reserve.
We advise clients to build an emergency cash reserve equal to three to six months of household expenses. If you are in the fortunate position to have done so, know that this type of emergency is exactly why you were saving. Allow yourself to tap into that reserve.
One silver lining to shelter-in-place requirements is that most households are spending less now than their typical budget. This means that a three- to six-month reserve can last even longer and can provide even more relief than you’d planned, especially when combined with disciplined spending.
Additionally, recovery rebates provided by the CARES Act may help supplement your cash reserve. The recovery rebates provide a one-time cash payment of up to $1,200 per individual (subject to income limitations) and an additional $500 per child. Many taxpayers are already receiving recovery rebates via direct deposit.
2. Consider accessing your home equity.
Strength in the housing market in recent years has helped many homeowners build equity in their homes. If you have sufficient home equity, historically-low interest rates may make this an attractive time to consider a home equity line of credit (HELOC).
Such a line of credit can offer flexibility of withdrawals and repayments (subject to minimum monthly payment amounts) and are generally far less expensive than other borrowing options, such as credit cards and short-term personal loans.
Remember that home equity loans or lines of credit, like credit cards and auto loans, are debt and must be repaid. While the cost of borrowing may be attractive today, financial discipline remains paramount to minimize the impact on your long-term financial plan.
3. Consider borrowing from your 401(k).
Many 401(k) plans (and similar qualified defined-contribution retirement plans) permit participants to borrow from their retirement account balance and repay the amount borrowed over a fixed term. While we typically encourage individuals not to borrow from 401(k) plans, you may be in the type of financial emergency that warrants an exception to that guidance.
The CARES Act expanded 401(k) borrowing capacity from 50% of the vested plan balance (up to $50,000) to 100% of the vested plan balance (up to $100,000) for loans taken between March 27 and September 23, 2020. Additionally, the typical five-year repayment period for these loans may be extended an additional year.
It’s important to note that not all retirement plans permit loans; this is a provision adopted at the individual plan level. Additionally, be mindful of the risks associated with borrowing from your retirement plan balance; most notably, your inability to repay the loan causes the loan to be converted to a distribution, which is subject to income tax (and potentially a 10% penalty). Further, if you lose your job or otherwise separate from employment, the loan must be repaid by the later of the due date of your next income tax return or 60 days from termination.
4. As a last resort, take a hardship withdrawal.
We advise taking a hardship distribution from your retirement account only as a measure of last resort. Like retirement plan loans, hardship withdrawal rights are determined at the individual plan level. Your plan may or may not permit hardship withdrawals, so it’s important you first check with your plan administrator.
First, if a withdrawal from your retirement plan is unavoidable, know that the CARES Act introduced a new type of distribution called Coronavirus-related Distributions that can minimize the impact of such a distribution on your long-term financial plan. For qualified individuals under age 59-1/2, such distributions are not subject to the normal 10% early withdrawal penalty. You will, however, still be required to pay income tax on the amount of the distribution.
Second, the CARES Act provides the opportunity either to repay a Coronavirus-related Distribution over a three-year period or to stretch the tax obligation ratably over the three-year repayment period. If you must take a Coronavirus-related Distribution, we encourage you to do everything you can to repay the distribution over the three-year period and avoid the tax consequences.
Responding to a Financial Emergency
Financial emergencies happen. While the specific causes of today’s financial emergencies are unlike those we have seen in the past, a good financial plan anticipates unknown hardships and provides contingencies for addressing them. If this is a challenging time for you, consider these options, and don’t go it alone. Reach out to your advisor for guidance and minimize the impact this short-term phenomenon has on your long-term financial success!
If you have any questions related to your financial plan, contact your advisor or request a member of our team reach out to you. We hope you and your families stay safe and healthy.
Joseph McNair serves as a Member and as a Senior Client Consultant with Warren Averett Asset Management. Click here to learn more about him or to reach out to him directly.