Lining Up Your Sources of Emergency Cash

Retirees depend on their nest eggs for much of their cash. When money is needed, they plan to raise it from either income generated by the nest egg or sales of assets, such as mutual funds or stocks. Most people enter retirement with no other ways of raising cash.

Selling more assets to raise cash incurs costs. One cost of that is likely to be capital gains taxes if the sales are from a taxable account or ordinary income when they’re taken from traditional IRAs. Annuities are another potential source of income, but you could owe income taxes and perhaps early distribution penalties on additional withdrawals, if the annuity allows access to the money.

With those options, another cost is you’re taking the money out of your nest egg and losing the future income or returns you were expecting. When your cash need arises during a bear market, you have to sell after sustaining declines in value and before the market recovers.

Your retirement plan should include a way to raise emergency money that doesn’t involve selling assets, incurring taxes or paying high interest rates. Your have the most options when a plan is made before retirement. But even after retiring you have options.

Home equity line of credit. The standard home equity line of credit (LOC) is for many people the easiest and least expensive source of cash. When you have some home equity and a decent credit rating, you should be able to set up an LOC before retirement.

Often there are low or no fees to set up an LOC, especially if you have other accounts with the lender. That way, there’s no charge until you actually draw against it. Otherwise, fees to set up an LOC are fairly modest.

With an LOC, you have the borrowing power, but don’t incur interest expenses until you actually borrow. You also don’t have to borrow the full amount of your limit. Borrow only the amount you need, even if it is only a fraction of the LOC’s limit. An LOC often expires if you don’t borrow any money within five years or so, but you should be able to obtain another LOC or extend it if you still have home equity and a good credit rating.

Interest rates on LOCs tend to be among the lowest you’ll find. With most LOCs, the interest rate is variable and tied to a short-term market rate, such as the LIBOR rate. You probably can find an LOC that allows interest-only payments for five years or so. After the term of the LOC, any outstanding balance usually is converted to a fixed 30-year payment schedule. You often can pay off the LOC at any time without a prepayment penalty.

It’s best to line up the LOC before retirement, because it is easier to be approved when you have steady employment income.

Reverse mortgage line of credit. I’ve discussed in the past the recent improvements in reverse mortgages. The latest discussion is in the November 2015 issue. Most reverse mortgages these days are FHA-guaranteed. Retirees don’t need much reliable income to qualify for an LOC if they meet the reverse mortgage requirements. You must be at least age 62, have home equity, and have a session with an approved counselor.

Reverse mortgage LOCs have higher fees than traditional LOCs, but you don’t have to pay them all up front. They can be part of the loan balance. You also probably won’t be able to have as high a borrowing limit as under a traditional LOC. But with a reverse mortgage LOC, you don’t need much income to qualify. You also don’t have to make any payments during your lifetime. You can make payments if you want to restore the full borrowing limit. But you don’t have to pay the loan as long as you live in the house. After you leave the house or pass away, proceeds from the sale of the house pay the loan balance and expenses. 8 October 2016 Bob Carlson’s RETIREMENT WATCH Robert C. Carlson wrote the book on retirement and retirement planning—twice: The New Rules of Retirement (Wiley, 2nd ed. 2016) and Personal Finance after 50 for Dummies (with Eric Tyson; 2nd ed. 2015). He also serves as Chairman of the Board of Trustees of the Fairfax County (Va.) Employees’ Retirement System (a more than $3.0 billion portfolio) and served on the Board of Trustees of the Virginia Retirement System (a $42 billion portfolio in 2005) from 2000-2005. He was educated at the University of Virginia School of Law and McIntire School of Commerce (M.S.) and Clemson University.

Margin loans. When some of your assets are in a brokerage account, you probably can set up a margin loan against the assets. The interest rate usually is very low. Your investment portfolio is your collateral for the loan. That limits the amount you can borrow. It also means that if your portfolio declines in value, the broker might sell some assets to pay part of the loan. That’s why it’s not a loan you want to maximize.

Note: Don’t set up a margin loan with an IRA. That could be considered a prohibited transaction and cause the entire IRA to be taxable.

Permanent life insurance. Permanent life insurance has a cash value account from which you either can take distributions or borrow. In an extreme case, you might surrender the policy in return for the entire cash value balance.

There are likely to be income taxes due when you take a distribution from cash value or surrender the policy. Loans from the cash value, however, are tax-free. Cash value loans usually don’t have to be repaid as long as there is a minimum amount in the cash value account. The loans and interest on them reduce the policy value eventually paid to the beneficiary.

Permanent life insurance also has the advantage of eventually paying a tax-free amount to the beneficiary or beneficiaries you name. You can deposit a lump sum with the insurer and instantly have both the policy benefit and cash value in place. I wouldn’t buy a permanent life insurance policy solely to establish a source of cash. But if permanent life insurance fits a need in your plans, it also can be a source of cash when you need it.

Of course, you should have savings in liquid assets to pay regular expenses and relatively low-dollar unexpected expenses. But you also should have a mechanism in place to obtain cash when an unexpected need arises.