What to Do When Your Emergency Fund Fails

By Dr. Daniel Smith, WCI Columnist

Most everyone has probably been in the unfortunate position of quickly needing a few extra dollars. If not, cheers to your good fortune so far. Either way, I’d like to highlight a few options that, should your emergency fund fail you, could be readily accessed in a pinch. Clearly, none of these options is perfect, but neither is an emergency fund.

The biggest complaint about an emergency fund is the cash drag that pulls down your portfolio. Cash yields a negative real return over time, and it just hurts to watch those dollars languish in a “high-yield” savings account earning 0.5%. The Bureau of Labor and Statistics reported that from December 2020 to December 2021, consumer prices rose 7%, the highest in 40 years. Your “high-yield” dollar is now worth 93.5 cents after that year. Even worse for your bottom line, inflation, as of this writing, is riding at about 8.5%.

Granted, this doesn’t happen year over year, but the thought is certainly sobering. In fact, a past WCI podcast guest, Big ERN, went on record to say that he doesn’t have an emergency fund because of the opportunity cost it presents. If anyone is interested in Big ERN’s specific blog post discussing the [dis?]utility of keeping an emergency fund, you can read it and the spectacularly long comment section.

This post likely won’t be comprehensive or cover all of the nuances about each option available if your emergency fund fails, but I hope this will be food for thought if you ever find yourself in a financial bind.

More information here:

Are Emergency Funds for the Weak Minded?

 

#1 Roth IRA Contributions

Roth contributions are completely tax- and penalty-free when withdrawn, period. The earnings themselves, however, must remain in the account for at least five years, and they are generally governed by the age 59 ½ early distributions tax. Fun fact: traditional IRA contributions can be withdrawn tax-free within the same tax year as they were contributed. The downside to withdrawing IRA contributions is that you lose that tax-protected space upon withdrawal. There is one particular caveat to this downside that I’d like to point out. In Publication 590-A, the IRS writes that “you can withdraw, tax-free, all or part of the assets from one Roth IRA if you contribute them within 60 days to another Roth IRA.” In theory, if you had a temporary cash crunch that would be alleviated within 60 days, you could take the cash out as a distribution and then contribute that same amount to another Roth IRA. The Roth 401(k) rules are a bit trickier, and amounts rolled into a Roth IRA from a Roth 401(k) are, as well. I would consult a CPA before making any moves.

 

#2 401(k) Loans

The IRS limits 401(k) and similar plan withdrawals to $50,000 or half of the plan assets, whichever is less. You must also pay back the principal amount and interest on the loan. While some plans may offer this option, some plans may not. If you do not pay back the loan, the IRS classifies this as a withdrawal subject to taxes and penalties. Also, the interest is not deductible as opposed to that which may be deductible if using a HELOC, as discussed below. When you take a pretax 401(k) loan, you’re taking out pretax dollars. You’ll be paying the loan back with post-tax dollars which will then be taxed again upon withdrawal in retirement. You’ll also miss out on the returns those dollars would have generated if they remained invested. Notably, the CARES Act allows for a $100,000 (or your vested amount in the plan) withdrawal if you qualify and if plan documents permit 401(k) loans.

More information here:

401(k) Loans Are Not an Investment

 

#3 457(b)/401(k)/403(b) Hardship Withdrawals

These kinds of withdrawals are plan-specific and, thus, they vary between employers. Generally, they’re for unforeseen or unique circumstances—like the unexpected death of a family member and the subsequent need to pay funeral expenses, property loss not covered by an insurance policy, illness, or accident. Interestingly, some of these aren’t quite so “unforeseen,” like college tuition and home-buying expenses. The IRS lists some of these here. Notably, hardship distributions are subject to income taxes and possibly even the 10% early withdrawal penalty. The CARES Act also provides an exception to the 10% penalty on COVID-related early withdrawals, and the taxable income is generally spread out over three years.

 

#4 HSA Distributions

Let me be clear here and say that you cannot use HSA money for non-medical expenses; however, you can use HSA money to reimburse yourself for previously incurred medical expenses at any time. What’s the silver lining to that emergency appendectomy? That’s right, those dollars spent removing that obstructed, arguably vestigial bit of colon can be reimbursed at a later date from your HSA.

More information here:

7 Reasons an HSA Should Be Your Favorite Investing Account

 

#5 529 Distributions

What if your emergency is less acute and more of an unforeseen longer-term issue? For example, that new attending job doesn’t have the patient volume for which you’d planned, and Navient still demands its pound of flesh. You moved to a location where public education leaves much to be desired and you find yourself in need of private K-12 funding for your budding Dorothy Hodgkin? You experienced a sudden illness or decrease in income for which you didn’t adequately insure, and you find yourself saddled with student loans that aren’t dischargeable in disability? While not a long-term fix, moving dollars from a 529 plan can ease the squeeze. The Secure Act allows holders of a 529 plan to use $10,000 toward educational debt. While it makes little sense (to me) to hold money in a 529 for yourself while carrying education debt, your child’s 529 can act as an emergency fund. You can change the beneficiary of a child’s 529 to yourself and use those dollars toward the educational debt. Since money is fungible, this can free up dollars elsewhere. Just be sure and put those dollars back into your child’s 529 (with interest). Similarly, K-12 education tuition can now be paid directly from a 529 account.

 

#6 Portfolio Loans

These are different from margin accounts where you pledge securities in order to purchase more securities. Portfolio loans are pledges of securities held in taxable portfolios given as collateral for cash loans. The rates, while typically lower than traditional personal loans, are variable. Similar to margin loans, however, there's the risk that the bank or lender may require you to pledge additional securities or pay down your loan if the value of your collateralized securities drops. In that vein, safer (less volatile) assets pledged usually allows you to take out a higher percentage of the pledged securities’ value as a loan.

 

#7 Loans Against Cash Value Life Insurance

If your policy has a cash value, then you can borrow against it. The collateral is, obviously, the policy itself; therefore, if you fail to make payments, you can lose the entirety of the cash value. At the risk of overstating the fact, there are a few good reasons to borrow against a whole life insurance policy: there’s no credit check as you’re borrowing from yourself, repayment rates are commonly lower than a bank loan and definitely lower than a credit card loan, borrowed cash still accrues some cash value back to you, and you can use the money for whatever you want. The downsides to this process are many. First, you have to have purchased a whole life policy. If you’re uncertain as to why this is listed as a downside, google WCI and “whole life insurance.” Second, you can allow the accrued interest and principal to exceed the limits set by the policy and lose the entire value accumulated. Third, there can be lots of flexibility with repayment options, like amounts paid and the length of the loan. I count this a “con” because it allows you to be more profligate about your spending and you run the risk of losing the policy value altogether; if you allow the policy to terminate, you could get hit with an income tax bill because you essentially took out money which is a combination of the principal taken from your premiums and then any earnings on that principal. Those earnings are viewed by the IRS as income.

More information here:

Is Whole Life Insurance a Scam?

 

#8 Home Equity Line of Credit

HELOCs are basically like using your home’s equity as a functional credit card to spend against. Since HELOCs are lines of credit, you have to request to draw down that line, which takes a few days. However, because the agreement has already been made regarding interest rates, repayments, etc., the acquisition of the money from the line generally takes just a few business days. As alluded to above, you can generally deduct the interest from HELOCs if the dollars are used for things that add to your primary residence’s value. Since we all know that a dollar used for a renovation is the exact same as the other dyed green cotton and linen rectangles in your wallet (money is fungible), it thus makes sense that a HELOC might be used to put an emergency roof on a house while you simultaneously invest a similar number of dollars, letting Uncle Sam absorb some of the financial blow via the interest deduction.

 

#9 Personal Loans

Need a decent dollar amount and hope those initials after your name will swing it (M.D. stands for “More Debt” and D.O. stands for “Debt Overload”)? In our world, it typically will! Personal loans are fairly tough to get if you’re the general public looking to Wells Fargo for five figures just because. However, those expensive initials can typically do the job. As in a traditional mortgage, your loan rate will depend on your debt-to-income ratio, your credit score, and the amount borrowed. However, because personal loans are generally unsecured (not backed by collateral), they tend to be higher than those which are collateralized. Also, I’m taking suggestions for how your profession’s initials can be adulterated into clever acronyms for being saddled with loads of debt (Ph.D. = Phantasmagorical Debt?).

 

#10 Valuable Personal Property

Hopefully your situation doesn’t get so bad as to need these guys, but your personal property can be borrowed against. Believe it or not, you can borrow against just about anything truly valuable: artwork, cars, jewelry, and firearms tend to be those commodities with the most available loan “markets.” As you would imagine, lenders against six-figure paintings are pretty niche professionals and, as such, can vary widely in rates or loans-to-value. Just in case anyone is in a bind and needs to sell their 12-gauge quickly, I’m looking for a good Beretta over and under.

 

#11 Credit Card Loans

I’ve saved the best for last because no detailed discussion of emergency funds could ever be exhaustive without considering the most ignoble of all loans: the credit card loan. With minimum interest rates at double digits and with daily accrual of that high-interest rate debt, the credit card loan ranks just above your local bookie in quality of lenders. I suppose the only upside is that you’ve technically already been approved and can get the money quickly. I’d go on, but I don’t think the WCI readership is the usual target audience for a credit card loan diatribe.

 

Hopefully, you’ll never need any of these offerings, but knowing what possibilities are available is half the battle. I didn’t mention a few other possibilities, like borrowing from family or relying on your spouse’s income, as the former seemed to veer into the awkward space of social obligation and the latter seemed to be a redundancy (hopefully you and your spouse’s incomes share the same function within your household). I’m sure I missed a few, so be sure to let me know which ones I overlooked in the comments.

What else could you do in the case of an emergency fund failure? Have you had to use any of the above methods? How did it work out? Comment below!