Ideally, you and your clients will communicate and collaborate to address any larger-than-average expenditures well in advance of the actual need occurring. And it’s even better if the client has a hefty checking or savings account balance that can be drawn on for big spending items, whether anticipated or not. But that’s not always possible. So, when you get that inevitable call from a panicked client saying “I need a lot of money RIGHT NOW,” here are the smartest ways to solve the cash crunch ASAP.
Liquidate the losers
Those clients who have investments held outside of retirement plans (such as stock or mutual fund shares) should check their cost basis.
If they have any positions with an unrealized loss, they can not only raise needed cash by selling those investments but also use the realized loss to offset taxable income or realized gains incurred in the current year, or in the future. Make sure the sellers avoid liquidating a position they have purchased within 30 days before or after the sale, which would then disallow the tax-deductibility of the loss.
Borrow if you can
Right-minded clients might be understandably debt-averse. But the willingness to pay a little bit of interest for a little while can buy time to determine the smartest long-term way to cover any large expenditures.
They should start by borrowing against any accumulated home equity, via a fixed-rate loan or home equity line of credit (HELOC). The application process is relatively painless, the interest rate is likely pretty low, and the interest may be tax-deductible.
If the clients don’t have much (or any) home equity to borrow against, they still may be able to get an unsecured loan from their bank or credit union. The annual interest rate may be in the single digits if the clients have a good credit rating.
The loan of last resort is the clients’ credit cards, either by charging the unplanned expenses to the card or taking a cash advance up to the available credit limit. But between potential origination fees, higher interest rates and the damage a sudden surge in a balance can do to their credit report, clients should use credit cards only when no other source is available and then attempt to pay the balance down as quickly as possible.
If the clients are facing looming higher education expenses, they should start by trying to obtain any available federal loans. The first step is to apply for financial aid via www.fafsa.ed.gov (and in the process, they may discover other available funds of which they would otherwise be unaware). The federal deadline for applying for financial aid is usually June 30, after the end of the academic year. But school and state deadlines are often earlier in the academic year. After the application is submitted, it can take anywhere from a few weeks to a few months before any funds are received.
Whatever the reason for the financial need, you can save your clients and yourself some future stress by having homeowner clients establish a HELOC now, which can then be tapped in an emergency without enduring the application and approval process.
Some gains, some pain
As much as it might sadden clients, the recent run-up in asset prices might make it an opportune time to sell some appreciated investments to pay for extraordinary spending, even if it means paying a little in capital gains taxes. The actual cost of the taxes might be even less than the interest charged to borrow the money for the emergency, especially if the sales are of assets with long-term capital gains (generally, held more than a year). And if the clients’ income is low enough, they may be able to land in the 0% long-term capital gains tax bracket and avoid any taxes on the realized gain. They can use this capital gains tax calculator and this income tax estimator to see where they stand.
Roth IRA contributions
Roth IRA owners over age 59 ½ can usually make withdrawals from their accounts with no taxes or penalties. But clients under that age can also get at least a portion of those Roth IRAs without any financial friction. They can withdraw the contributions they’ve made to their Roth IRAs at any time, for any reason, with no taxes or penalties whatsoever. The IRS lets Roth IRA owners designate any withdrawals as “contributions,” until the owners have withdrawn an amount equal to what they contributed.
But although there will be no taxes or interest if clients raise money by withdrawing their Roth IRA contributions, they may jeopardize their retirement by taking funds out before they have reached the goal of the account. Therefore, it’s crucial that, as soon as the clients’ financial crisis subsides, they continue to make annual Roth IRA contributions for as much as they are eligible and can afford.
401k loans
Working clients can take loans from the “vested” portion of their 401k plans, if the terms of the employer-provided plan allow it. The legal limit is the lesser of $50,000, or 50% of the vested balance. There is no application involved and taking out a 401k loan won’t affect the client’s credit score. There are no taxes on the “borrowed” money at the time it is distributed. The borrower pays herself interest on the loan, at a rate set in the terms of the employer-sponsored plan. The repayment of the loan is usually made through payroll deductions, and some plans don’t allow the borrower to contribute to the plan until the loan is repaid (the longest term allowed is usually no more than five years).
But if the client loses her job while the 401k loan is outstanding, she has to repay the balance by the following year’s tax deadline (usually April 15). Any unpaid amount may be considered a nonqualified distribution, and the client could owe income taxes on the amount (plus a 10% penalty if she is under age 59 ½).
Kevin McKinley is principal/owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of Make Your Kid a Millionaire (Simon & Schuster).