Avoid these 5 ways to pay for emergencies
When you need the money fast, you might be able to come up with several ways to get it. But they may not be the smartest solutions.
1. Using credit cards
Emergencies are never fun to begin with—do you really want to make it worse by paying more than you have to? Interest rates on credit cards can be sky-high. And don't forget about potential late fees, the risk of going over your credit limit, and the fact that your credit score will take a hit.
2. Withdrawing your retirement money
Using money that you've earmarked for retirement (or another goal, like college) could hurt you in a number of ways.
If you take money from a tax-deferred account—a traditional IRA, a 401(k), or a 529, for example—you'll be hit with a 10% penalty in most cases. And don't forget to set aside part of what you withdraw, because you may need to pay income taxes on it as well.
So, for example, if you withdraw $10,000, you could be looking at total taxes and penalties of $3,500 (if you're in the 25% tax bracket)—leaving you with only $6,500 to deal with your emergency.
Withdrawing from a 401(k) means you'll pay a lot more
And that might not even be the worst part.
The money you withdraw could eventually threaten your ability to reach your goal. Going back to our example, $10,000 might seem like a small drop in your retirement bucket, but because you'll also miss out on years of compounding, you could be looking at a final loss of more than $57,000.
The true cost of taking a retirement withdrawal
This hypothetical example assumes that you miss out on 30 years of compounding at an annual 6% return. It doesn't represent any particular investment nor does it account for inflation.
Figure you'll just take some of your 401(k) money as a loan instead? Remember that if you fail to pay back the loan—or if you leave your employer and can't repay the loan immediately—you'll face the same taxes and penalties that come with a withdrawal.
3. Counting on family or friends
Sure, someone might be willing to lend you money in a time of need … at least the first time. But wouldn't you feel better not placing a financial burden on those you care about?
4. Relying on insurance
You pay for insurance so that when an emergency crops up, you're all set, right? In reality, sometimes insurance claims are denied, require you to pay a deductible, or are only partially covered.
Trying to insure your way out of all possible financial hardships isn't a great idea, either.
Instead, think about taking any money you spend to insure electronics, appliances, and pet care and putting it in your emergency fund.
If you truly need the money, you'll be covered. If you don't, congratulations—your emergency fund just got a little fatter.
5. Selling risky investments
Maybe you've got some "fun money" stashed away in stock or bond investments, but you shouldn't consider that an emergency fund.
By definition, emergencies happen when you're not expecting them. If you need to pay for them by tapping into your stock or bond holdings at a time when they're taking a beating in the market, you'll lock in your losses.
So how should you pay for emergencies?
Opening a savings fund to use strictly for unexpected expenses has its benefits.
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Get the basics on emergency funds
WHERE DOES AN EMERGENCY FUND FIT INTO YOUR PRIORITIES?
You won't pay any income taxes on the amount your account earns until you take the money out. (Note that with Roth accounts, assuming you meet all requirements, the earnings become tax-free at that time.)
A type of account created by the IRS that offers tax benefits when you use it to save for retirement.
When earnings on invested money generate their own earnings. For example, if you invested $5,000 and earned 6% a year, in the first year you'd earn $300 ($5,000 x 0.06), in the second year you'd earn $318 ($5,300 x 0.06), in the third year you'd earn $337.08 ($5,618 x 0.06), and so on. Over longer periods of time, compounding becomes very powerful. In this example, you'd earn over $1,600 in the 30th year.
This bar chart shows how a $10,000 investment can potentially increase to 5 times its size over the course of 30 years. When you keep your money invested (versus withdrawing it), it has a greater opportunity to grow.
Over 3 years, your money could grow to $11,910. Over 6 years, your money could grow to $14,185. Over 9 years, your money could grow to $16,895. Over 12 years, your money could grow to $20,122. Over 15 years, your money could grow to $23,966. Over 18 years, your money could grow to $28,543. Over 21 years, your money could grow to $33,996. Over 24 years, your money could grow to $40,489. Over 27 years, your money could grow to $48,223. And over 30 years, your money could grow to $57,435.
An asset (like a stock or bond) purchased in the hope that it will increase in price or pay income.