Personal Finance

Savings or loan: which should you turn to when hit with an unexpected expense

Key Points
  • If you have emergency savings intended for unexpected situations, it could make sense to tap that account and then replenish it as quickly as you can so that the money is there when you face a similar need again.
  • If you'd have to liquidate assets from a retirement account to get the cash, make sure you understand the financial implications — both short and long-term — of doing so.
  • Consider the tax aspects of all withdrawals and all borrowing options.

If you run into a big expense and are eyeing tapping your savings, make sure you know how the move would affect your finances.

While there are benefits to paying cash for a big-ticket item or unexpected expense instead of financing it and paying interest on the borrowed money, doing so may cost you more than you intend.

It depends on how you secure the money.

"People like the convenience and simplicity of paying cash for something, but it's not always the best thing to do," said Certified Financial Planner Scott Bishop, executive vice president of financial planning at STA Wealth Management in Houston.

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If you have emergency savings set aside for the unexpected, it could make sense to withdraw what you need and replenish the account as quickly as you can so that the money is there if there's a repeat need.

On the other hand, if you'd need to liquidate assets from a brokerage or retirement account to get the cash, make sure you've considered the financial implications before tapping either to fund an unplanned expense.

For retirees

In most cases, you can start making withdrawals from your retirement accounts — either a 401(k) plan or an individual retirement account — once you reach age 59½. If you are older than that and are debating whether to make a big withdrawal, the first step should be to evaluate how the move would affect your retirement plan.

"You don't want to turn a short-term funding need into a long-term, permanent problem," said CFP Michael Yoder, principal and investment advisor at Yoder Wealth Management in Walnut Creek, California.

"What you take out would no longer be earning money for you and would lose the benefit of compounding," Yoder said.

Same goes for investments you hold in a brokerage account: Check to see how selling those assets potentially would impact your portfolio over time.

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Taking a big chunk of money from either type of account could cost you in taxes.

While Roth versions of both 401(k) plans and IRAs typically come with tax-free withdrawals once you reach 59½ (unless you've held it less than five years), the traditional forms of those two retirement accounts do not.

For non-Roth 401(k) plans and IRAs, qualified withdrawals are taxed as ordinary income.

"If you take a big amount all at once, it could push you into a higher tax bracket," Bishop said.

And if you sell appreciated investments in a brokerage account, you'd face capital gains taxes on your profits. Short-term gains — those on investments held one year or less — are taxed as ordinary income, with rates ranging from 10% to 37%, depending on your income and filing status. Long-term gains are taxed at rates of zero, 15% or 20%, with higher-income taxpayers paying more.

If you take a big amount all at once, it could push you into a higher tax bracket.
Scott Bishop
executive vice president of financial planning at STA Wealth Management

If you happen to use the withdrawal to buy another asset, you also could lose liquidity.

"Say you withdraw $150,000 to buy a house or an RV, and a couple years from now you have an expensive health issue or emergency," Bishop said. "Now that $150,000 is tied up in a hard asset — it isn't really liquid."

And, if the stock market is down at that point, the idea of another retirement-account withdrawal could be even less appealing.

Meanwhile, if your retirement plan can easily survive the withdrawal, tapping those funds could be an easier decision.

However, there's a chance borrowing the money could make more financial sense. You'd have to do some math and make some assumptions about your portfolio's earnings.

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"As long as the rate you're earning on your investment is higher than the amount you're paying on the loan, the math shows it looks better to leave investments where they are," Bishop said.

Of course, investment returns are rarely guaranteed, while interest on a loan generally is (although it might fluctuate, if it's an adjustable rate).

For the younger crowd

Roughly 80 million U.S. workers actively participate in their employer's 401(k) plan (or similar defined-contribution option), according to the American Benefits Council. While many of those plans — especially at large companies — allow you to take a loan from your 401(k) and repay yourself with interest, it doesn't mean it's necessarily a good idea.

"The money is taken out of the market so you aren't earning anything on it," Bishop said.

Taking an outright withdrawal from your 401(k) could be an even worse option.

If you're younger than 59½, you'll typically pay a 10% penalty on any amount withdrawn before age 59½, except in certain cases. That would be on top of the money being taxed as ordinary income.

For Roth IRAs and 401(k) plans, you can avoid penalties if you've held the account for at least five years, although you'd owe taxes on the earnings in most cases.

Loan options

If you do decide to finance your big expense, make sure you evaluate all options available to you.

Homeowners often eye the equity in their house, in either the form of a loan or line of credit. The average rate on a loan is 5.87%, according to Bankrate. The average rate on a $30,000 home-equity line of credit is 6.75%. The better your credit score, the lower the rate you'd likely be able to snag.

Be aware that under the new tax law that took effect in 2018, the interest on any loan secured by a house is only deductible if the money is used to purchase, build or substantially renovate your home.

Even if you clear that hurdle, the only way to get the tax break would be if you itemize on your tax return. For married couples, that means having itemized deductions worth more than the current standard deduction of $24,400. (For singles, it's $12,200; and for head of households, $18,350.)

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However, if you do itemize, that deduction would reduce the cost of tapping the equity in your house. For example, if you were to get a loan with 5% interest, and you're in the 20% tax bracket, the deduction would reduce the rate you're paying on the borrowed money to 4%.

"Always look at the tax consequences to see the cost of borrowing," Bishop said.

Turning to credit cards to finance a major purchase is typically not a great alternative. The average rate is 17.76%, according to CreditCards.com's latest weekly report. And cash advances typically run at least several percentage points higher than the rate you're charged for purchases.

"If you're paying 20% interest, that's a tough hole to dig out of," said Yoder, of Yoder Wealth Management.

Likewise, although a personal loan could be an option, these unsecured loans come with an average interest rate of almost 11%, according to the latest data from the Federal Reserve. For people with poor credit, the rate can be double that amount.

Risky, but sometimes used

Depending on your financial situation, you may have access to a margin loan through your brokerage account. In simple terms, this involves having your investments in the account serve as collateral. The interest rate is about 8%, Yoder said.

These loans can be risky. If your investments drop a lot in value, you may need to come up with the cash to cover your brokerage's minimum margin-account balance requirements.

"It's not a long-term solution," Yoder said. "It's a stop-gap."

For example, he said, someone who knows they'll get a work bonus in six or 12 months might explore a margin loan rather than sell stock to fund their immediate need.

"Instead of selling and triggering a huge tax bill via capital gains, they use their stock portfolio as collateral in a margin loan," Yoder said.

However, he said, it's a route best taken with guidance from a financial advisor.

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