NEW YORK – If desperate times call for desperate measures, does that mean we can all break into our 401(k) accounts now?
As job losses mount amid a persisting recession, a few golden rules of personal finance are rapidly losing their luster. Resources you once considered off limits — such as your retirement fund — might suddenly be beckoning as you scramble to make ends meet.
You might be wondering, if not now, when can you fall back on these reserves?
The first step is making sure you truly have no other options.
“You need to re-evaluate your entire situation,” said Glen Buco, a certified financial planner with West Financial Services in McLean, Va. That means scrutinizing your lifestyle for any possible spending cuts.
If you still can’t make ends meet, here’s a look at some common money taboos and the cost of breaking them.
TABOO #1: TAPPING YOUR 401(k)
• HOW IT WORKS: There are a couple different ways to tap your 401(k), some more harmful than others.
The rules vary depending on your company’s plan, but you can typically borrow as much as half your vested 401(k) balance up to $50,000. While not advised, it’s better than simply taking an early distribution, which requires you to pay a 10 percent penalty and income tax on the amount if you’re under age 59 1/2.
In some limited emergency circumstances, you can take a hardship withdrawal without paying the early distribution penalty. But you still need to pay income tax on the money.
The rules for what qualifies as a hardship are strict. Medical expenses, repairs for major home damage and tuition are some scenarios that might qualify. Not all employers allow hardship withdrawals.
• WHEN TO CONSIDER IT: The advantage of borrowing from your 401(k) is the favorable interest rate, which is typically around the prime rate (currently 3.25 percent). So it might be a reasonable option if you have no other way to pay off a credit card balance with a much higher interest rate, said Michael Kresh, a certified financial planner and president of M.D. Kresh Financial Services Inc. based in Islandia, N.Y.
• RISKS & REPERCUSSIONS: The impact of borrowing from your 401(k) depends on your age, salary and contributions. The younger you are, the bigger the dent will be on your retirement savings because of the effect of compound interest.
There are other risks to consider, too. If you default on the loan, it’s considered an early distribution and you have to pay income tax and a 10 percent penalty. Your plan sets terms of default.
Another risk is losing your job. At that point, you’ll need to pay back the entire loan within 30 to 90 days or it’s considered an early distribution.
Loans can typically be repaid within five years; loans for buying a home can be repaid over 15 years.
If you do take a hardship withdrawal, you generally can’t make new contributions to your plan for at least six months.
TABOO #2: CHARGING EVERYDAY EXPENSES
• HOW IT WORKS: You’re in a tight spot and decide to charge bills on your credit card. This can be an especially treacherous practice today, with credit card companies hiking interest rates ever higher.
• WHEN TO CONSIDER: This is only an option if you’re positive you can pay off the balance quickly — no later than a month or two, said Charlotte Dougherty, a certified financial planner with Dougherty & Associates in Cincinnati.
Another situation is if you have a credit card with special, low interest rates.
• RISKS & REPERCUSSIONS: It might seem like an easy fix at the time, but consider how quickly credit card bills can overwhelm you. If you charge a $100 cell phone bill on a card with a 20 percent interest rate, your balance more than doubles in just four months if you don’t make any payments. Interest rates on cards can be as high as 30 percent.
So unless you can make at least the minimum payments, this path will likely dig you into a deeper hole. And unlike interest payments on home equity loans, interest payments on credit card balances are not tax deductible.
TABOO #3: RAIDING EMERGENCY SAVINGS
HOW IT WORKS: Let’s assume you have an emergency fund. For many people, they’re forgotten or delayed New Year’s resolutions that never materialized. Here’s a refresher course just in case.
Emergency funds typically cover three to six months of living expenses, depending on your profession and the likelihood that you’ll be out of work for an extended time. You might want to err on the side of safety these days, with the job market in shambles. Unemployment is at a 25-year high of 8.5 percent and expected to climb higher by year’s end.
• WHEN TO CONSIDER: The idea is that you only use the money for unforeseen, temporary costs, such as medical expenses or bills during brief spells of unemployment.
But before you start raiding the fund, ask yourself whether your situation is truly an emergency. Don’t make a habit of dipping into the fund whenever you incur a hefty expense. What seems like an emergency now might not look so bad in three months, when you can’t scrape together money to cover basic bills.
Check if there are resources you aren’t using, such as public programs. Ask lenders if you can work out a more manageable payment plan.
• RISKS & REPERCUSSIONS: Many people who lose their jobs start plowing through their emergency funds without making any adjustments to their lifestyle. But if you’re unsure how long it will take to find a job, you need to make your cash last as long as possible.
As soon as you need to tap into your emergency fund, start developing a game plan for how you’ll get by once the money is gone.