Hard times call for hard money choices

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Financial advisers typically recommend setting aside at least three months’ worth of living expenses in a safe, liquid account in case of prolonged unemployment, sudden medical emergency or other unforeseen financial demands. This is called your “financial cushion.”

Yet in today’s economic climate, is it really practical?

Tapping your savings
  1. Saving during recession
  2. Spending during recession
  3. When to borrow
  4. Asking loved ones
  5. Money to avoid

With the proverbial “rainy day” now closer than ever, you may be tempted to dip into your savings, not add to them. So under what circumstances is it OK to spend your reserves? Are there better sources of ready cash to keep you afloat?

Saving during recession

“Don’t expect to maintain your current standard of living,” says David Hefty, CEO and co-founder of Cornerstone Wealth Management in Auburn, Ind. “If you have children, use this as an opportunity to teach them about sacrifice … Use this horrible economic downturn as a positive and don’t be a victim.”

To be sure, there’s no single, simple formula for not becoming a victim. What’s right for one person might not be right for another.

“There’s no cookie-cutter or off-the-shelf answer to the question of what to do about your nest egg in hard times,” says Rob Barmen, executive vice president at BPU Investment Management, a financial advisory firm in Pittsburgh. “It really depends on your situation.”

Ironically, despite these recessionary times, Americans are suddenly managing to put away more money, not less.  In early March, the U.S. Commerce Department announced that personal savings as a percentage of disposable personal income surged to 5 percent in January this year, the highest level since March 1995.

“Consumers are fearful right now,” says Michael M. Eisenberg, a certified public accountant and personal financial specialist in Los Angeles. “If they have a job, they’re afraid they might lose it.  In a way, that’s the silver lining of this crisis. It’s showing people they can and must save.”

Spending during recession

Naturally, there are times when you can’t save. There may be times when you’re tempted to spend your savings. That’s fine, if you’re prudent.

Job losses or urgent medical needs and other emergencies are valid grounds for withdrawing from a rainy-day fund, Eisenberg says, but a sale at Bloomingdale’s doesn’t count.

“The emergency fund is there to get you through unanticipated crises,” Eisenberg says.  “You can tap into it for spontaneous, one-time events, such as an urgent car repair or, if you’ve just lost your job, to make your next property-tax payment, that kind of stuff.”

At other times, though, it can be better to borrow money than spend your savings. Interest rates are enticingly low at the moment, except on credit cards. If you can borrow at a lower rate than you earn from your savings, it might be a wiser option. However, if owing money keeps you awake at night, it’s probably not a smart move.

When to borrow

If you have to borrow money, a home-equity loan is often the best choice. The interest payments are tax-deductible.

“If you need to make repairs to your house, for example, this is an appropriate source of funds,” Eisenberg says. “If your kids are in college and they have a semester or two to go, and you want them to finish that education, I can see using a home-equity loan. Not for all four years of college; that doesn’t make sense, but for short-term, major expenditures.  Don’t use it for vacations or buying sprees.”

But home-equity loans can be hard to get in the credit crunch, and they’re almost impossible to find if you’re unemployed. What’s more, property values have plummeted, and you don’t want to tap the diminishing equity in your home if you don’t have to. If you sell your home later, before paying off the loan, you’ll pocket less of the proceeds because a larger chunk is going to your lender.

Some financial advisers prefer other options. For one, see if your life insurance policy has a cash value. Many “whole” or “universal” life policies, as opposed to “term” life insurance, invest a portion of your premium payments in a separate tax-deferred account. It builds value over time so that some benefits can be paid out before your death as well as after, says Stacy Francis, a financial planner in New York.

“It’s your money, it’s in cash and there are usually no penalties for tapping into it,” Francis says.

But there are two caveats about tapping life insurance:

1. Any cash you withdraw will reduce your after-death payout to heirs. It’s not always a dollar-for-dollar formula, either. In some cases, you could be reducing your death benefit by more than the amount you withdraw. Policies vary, so check with your provider before taking out funds.

2. Don’t access the cash value of your life insurance by taking out a loan against it.  Often policies offer loans at a lower rate of interest than banks with the cash value of your policy serving as collateral. Nevertheless, you are paying interest, which makes anything you purchase with the funds that much more costly. In some cases, the loan plus interest can be deducted from your death benefit rather than paid back in your lifetime.  This may seem tempting, but again, it diminishes what you leave your heirs, says Eleanor Blayney, a consumer advocate at the Certified Financial Planner Board of Standards in Washington, D.C.

Asking loved ones

Another choice is to ask friends or family for money. Doubtless this will entail emotional strings, yet that’s no reason to avoid it. “I certainly would hope my child would come to me before doing something foolish,” Blayney says.

If you’re going to borrow from an individual, draw up formal loan papers to clarify terms and clear up potential misunderstandings. For advice in how to do that, see “Borrowing from family.”

Often, family members prefer to give the money as a gift with no promise of repayment.  Parents or grandparents may enjoy doling out inheritance money while they’re still alive. In so doing, they can avoid estate taxes while seeing how their heirs use it, says Bill Schultheis, investment adviser and principal at Soundmark Wealth Management in Kirkland, Wash. In 2009, individual benefactors can give up to $13,000 a year as a gift — married couples, twice that — without a penalty. Larger gifts could incur gift taxes.

Money to avoid

In desperate times, smart people can make stupid choices. Here are several warnings about sources of ready cash to avoid:

  • Do not dip into your retirement accounts.  If you do, you’ll face taxes that would otherwise be deferred until retirement and substantial penalties for early withdrawal.  Plus, you will need that money when you get older.

“401(k)’s and IRAs give you creditor protection,” Blayney says. “So if you’re on your way to bankruptcy, remember that those assets are protected.”

  • Avoid payday-advance or tax-refund anticipation loans. They carry very high interest rates for money that’s yours anyway.
  • Don’t be tempted by a reverse mortgage unless you’re a senior citizen who has paid off most of your mortgage and you want to remain in your home and have no heirs to leave it to. The extra cash is generally not taxable, but look out for high hidden fees.

However you do it, taking charge of your financial situation can be as comforting as it is necessary.  Still, for some, the best comfort may be recognizing that tough times don’t last forever.