5 common mistakes in a bad economy

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Consumers have plenty to worry about during a challenging economy, and making a wrong move in personal finances could make a bad situation worse. Obtaining cash through credit cards, retirement plans and home equity could end up being a costly quick fix. And complacency over personal investments and looming college costs could lead to missed opportunities for keeping hard-earned dollars.

Here’s how to avoid some common pitfalls during an economic downturn.

1. Living la vida Visa

One of the most common responses to a financial crisis, such as a job loss, is to continue spending with credit cards, says Gail Cunningham, spokeswoman for the National Foundation for Credit Counseling.

“We’re great spenders but lousy savers,” Cunningham says. “We’re a hopeful lot of people. We keep thinking that our ship is going to come in.”

But the reality is that it typically takes a job seeker one month to replace $10,000 of lost income, she says. So a prospective employee should expect it will take five months to replace a $50,000-a-year job.

Rather than continue a lifestyle financed by credit cards — and compounding debt in the process — consumers should “circle the wagons” by figuring out where they spend their money, Cunningham says.

Just as calorie-counters keep a log of every meal and snack, consumers should keep a meticulous watch on incidental purchases like meals in restaurants, nights out at the movies, and, of course, gourmet cups of coffee. Think of it as an expense report to yourself.

“Nobody likes to do it, but you can do anything for 30 days,” she says. “Tracking your spending is one of the most basic elements of financial stability.”

Once consumers have a handle on spending, do they have go cold turkey on all of the good life’s trappings? Not necessarily.

Cunningham suggests that cutting back on some expenses is better than cutting them out.

Comb through cable bills, cell phone plans, and other services for lower-cost alternatives.  Folks who haven’t watched HBO since the finale of “The Sopranos” or never started a conversation with a text message may rein a few bucks per month by dumping these options.

What to do: credit card spending
  • Stop using credit cards.
  • Track monthly spending.
  • Cut down, but don’t cut out, on lifestyle spending.
2. Invading your nest egg

Economic downturns have a way of drying up consumers’ liquidity. Meanwhile, creditors only get thirstier. But as tapped-out consumers have fewer options to get cash, they may be tempted to withdraw from an IRA or borrow from a 401(k) plan. Taking cash out of a traditional IRA can lead to a double-whammy of a 10-percent penalty and taxes of at least 25 percent if the individual is younger than 59½, says Ira Marks, a Certified Financial Planner based in Lawrenceville, N.J.

For example, a couple with a combined yearly income of $100,000 who withdrew $25,000 would pay a $2,500 penalty, plus a tax of $6,250 for a total of $8,750, Marks says. State taxes would also be added.

Taxes and penalties would be more for a couple who earns more money. A couple who makes $200,000 annually would pay $10,833 for the same $25,000 withdrawal, Marks says.

There are exceptions, such as if the withdrawal is made to pay for medical expenses, he adds.

Another caveat to note: If the money is replaced within 60 days, there will be no taxes or penalties — good to know if you need a quick infusion of cash for a college tuition payment before a commission check comes in, for example.

“But most people don’t become aware of that until they are working with their tax preparers the following year,” Marks says. By that time, the 60-day window to avoid losing money to taxes and the penalty has closed.

What to do: investing your nest egg
  • Consult a tax preparer or financial planner before tapping into retirement plans in order to understand all of the associated costs.
  • In some cases, withdrawals from a traditional IRA can be subject to a federal 10-percent penalty and can be taxed. But an individual can avoid these costs if the withdrawal is paid back within 60 days.
  • Withdrawals from a Roth IRA can be subject to a 10-percent penalty, but no additional taxes.
  • Withdrawing from an IRA should be the last resort, because it diminishes money set aside for retirement. However, if faced with a catastrophe, such as foreclosure on a home, it may be a justifiable move.

For a Roth IRA, a person younger than 59½ who withdraws the earnings within the first five years of opening the account would pay the 10-percent penalty and taxes. Contributions can be withdrawn at any time tax and penalty-free.

Consumers who may be leaving their jobs soon — either voluntarily or not — may want to think twice before borrowing against a 401(k) plan. Once an employee leaves a company, the loan turns into a taxable withdrawal, triggering the federal government’s 10-percent penalty, Marks says. 

3. Paying for college without applying for aid

An Aug. 20 Sallie Mae/Gallup survey found that a fourth of families with children in college did not send in the Free Application for Federal Student Aid, or FAFSA, for the 2007-2008 school year.

“It’s probably the simplest thing you can do to make sure you’re not missing out on free money or low cost money,” says Patricia Nash Christel, a Sallie Mae spokeswoman.

The federal government uses the information on the form to determine an applicant’s eligibility for Pell Grants, subsidized Stafford loans and other financial aid, she says. Private organizations often use the information when awarding scholarships.

The survey also found that only 9 percent of the 1,404 families questioned reported using a 529 savings plan, a state-sponsored investment account that accumulates tax-free earnings. Those with a 529 plan used up to $8,000 toward last year’s education costs, which on the average were $14,628, according to the survey.

What to do: paying for college
  • Complete and send in the FAFSA, even if the fall semester starts next week, to be considered for federal grants and loans for college.
  • Families with younger children should investigate college savings options including 529 plans.
  • Find plans administered by each state as well as track loan rates and calculate contributions to the plan at Bankrate.com’s College Finance page.
  • Sallie Mae’s Upromise.com Web site offers a rewards program that allows consumers to contribute to 529 plans through everyday purchases.
  • Other college savings options include custodial trust accounts, in which a child owns the money but the account is controlled by a parent or guardian. Coverdell Education Savings Accounts may be used to pay for elementary and high school expenses a well a college.

Meanwhile, 38 percent of the families surveyed paid for tuition, room and board, and all other college-related expenses with personal income.

Christel says that parents are so committed to sending children to college, seeing it as an investment in their family’s future, that they often give little thought given to education costs and what happens after graduation, such as paying back loans and what the student’s income will be after school ends.

4. Investing inertia

Long-term investing used to be easier: Pop the cash into the mutual funds and annuities and watch the returns rise like bread in an oven. But even consumers with a little dough are prone to avoiding the complex implications that the volatile stock market may have for their investments.

Lyle Benson, who owns a financial services firm in Baltimore, says that investors can get lulled into complacency when they should be reviewing their asset allocations to make sure they are keeping up with earnings targets.

While a portfolio should always have some amount of stocks to ensure growth in the long run, keeping too many stocks during a down market can be costly, Benson says. Sheltering cash in treasury bills or bonds can help a portfolio hold up in a bear market.

Older investors are often attracted to the low risk of CDs, especially since some analysts are projecting rates will increase in the coming months.