Recently Unemployed...Some Things to Think About

In recent years the US population has had no shortage of those whom have had the unfortunate experience of a job loss. As of August 2012 we currently have and official unemployment rate of in excess of 8% of the population. This data is based on the U4 report from the department of labor. The U6 data which is reflective of those no longer being counted is closer to 14.5%. If you have been or may be in the future one of them, it’s probably a good idea to look at some action steps should you find yourself in such an unfortunate situation.

Clearly your first order of business is to begin looking for other work. While gainfully employed, it’s always a good idea to have an emergency fund set aside. In reality far too few Americans actually have such reserves. A good target amount to have set aside in savings or cash equivalents is normally about 6-12 months of expenses. However if you have been recently let go from your employer, you are no longer planning for an emergency but rather you’re living it. At that point it’s a good idea to start to attempt to raise closer to 3 years of emergency funds in such a weak labor market. In some cases one might be in a field that they feel makes them highly marketable and this may be over kill. That’s possibly the case. But for those whose skill level in the labor force is not in as great a demand, you want to be overly cautious.

The key here is what are your expenses ??? All of us should maintain a budget record. This does not mean that it is a blue print of constraints by which you live your life. But rather an accounting record of where money goes. This can be done with a simple excel spread sheet. In doing so it is wise to categorize expenses into various items and sub categories. Household expenses such as mortgage, property taxes, insurance, utilities etc. Once you have a full accounting, go through each item and classify them as essential or discretionary. This is an exercise I complete annually with each client in my practice. The reality for most clients is that they often find anywhere from $1,000-$2,000 per month that they really didn’t think about as an expense until they itemized it. Some of these costs are vacations, holiday & birthday gifts. Sometimes the simple things like stopping for a cup of coffee and a newspaper. Yet these items add up. This exercise is useful to help track your financial planning progress, yet you can also more readily see what can be eliminated in an emergency.

If you are unfortunate enough to find yourself unemployed, some items that must stop are easy to uncover. Clearly the Tuesday night poker game may not be the best idea. Yet you also don’t need to make contributions to your kids college account either. It’s important to discuss these things as a family and if you have children make sure they’re aware of the temporary sacrifices that need to be made that might directly affect them. No kid wants to be told that you can’t pay for their dance lessons this year. However if you can make them see it’s that or we lose the electric in the house, the may be more understanding.

Where do you raise cash from…The best place is always savings, CD’s and money markets. The two places you want to avoid as a last resort are credit cards and retirement plans. Your 401k plan will not allow for a loan when you’re no longer employed. If you already have one, many plans will require that you satisfy it in full upon termination. Credit card charges and cash advances will come back to haunt you 10 fold with the astronomical interest rates you’ll be forced to pay. If there are EE/EEE bonds that have matured, you can cash those but will realize the interest as income tax in the year they were cashed. If you’re let go from your job towards the end of the year try to push off cashing in anything with a tax liability into the first of the year. While unemployed your tax rate will be close to zero from unemployment and you may end up with no tax liability on the interest earned. The same is true with a retirement account withdrawal. If because you have no other resource you’re forced to draw on a 401k/IRA and can make it to the next tax year, although you may have a penalty for pre-retirement distributions, the tax hit may be ZERO if you were unemployed the majority of the year. That largely will depend on the amount of the distributions and any deductions you have to offset the income. Additionally any amount withdrawn can be re-deposited back to a retirement account within 60 days tax and penalty free. So if you’ve drawn funds throughout the year and then find work, look back at the more recent withdrawals to see if you have some funds that can be returned.

72T…If again your only recourse is to utilize a retirement plan because you have no other assets to work with, then 72T may be an option. If you’re under the normal retirement age, the IRS allows for penalty free distributions from pre-taxed IRA’s in what is called substantially equal periodic payments. There are three separate formulas that can determine the amount of your monthly payment. Under this formula you must continue the payments without interruption up to age 59 ½ & a minimum of 5 years (Whichever is Longer). Any failure to continue the formula will result in reinstating the penalty on the entire amount withdrawn. The 72T calculation is not based on all of your retirement assets but rather a specific account. So if you have 300k in and IRA and can produce the income required from 100k, then simply split the IRA in to two separate accounts for the purpose of the calculation. Additionally be cautious of this option if you are much younger. Starting this option at an age of 45 would not likely be wise. You would be locking yourself into 15 years of distributions. In all likelihood you would have been back to work long before that. Someone closer to age 55 may consider this possibility.

ROTH IRA…In the case of a ROTH, you can take at any time the contributions from the account without a penalty or the tax. The key is the account must have been in existence for at least 5 years. Any withdrawal of the growth that occurred in the account will be taxed and penalized if drawn before 59 ½.

Life Insurance Policies…While in most cases I tend not to favor policies that build a cash value, many already have them. Often times you can draw or borrow against that cash value temporarily with little to no tax liability or penalty. This will depend on various factors so you need to have your agent examine the policy features and discuss this with you.

Annuities…Non-qualified annuities are a possibility. If you have a loss on the contract you can recover the full balance tax and penalty free. If there is a gain you must first draw the gain and pay the tax. Contracts that have a gain make this a less attractive option. Depending on the age of the contract there may be a surrender fee. Check with your advisor to determine any such fees.

Investment Accounts…In some cases you may have a stock portfolio of investments that you have accumulated or inherited outside of a retirement account. Before you sell anything, check your cost basis and see of its producing a gain or loss that is yet to be realized. If there is a gain you have a few options. One is check with your tax advisor on what kind of carry forward capital losses you have that can be used to offset the reporting of the gain. If it sizeable and you worked most of the year, selling it in the same year may trigger the Alternative Minimum Tax (AMT). If there are no losses available to use from past investments and you want to defer the sale until the following year to defer taxes you can. The risk then becomes that you are depending on a stock or group of stocks to fund an emergency fund. Since the stock market has inherent short term volatility, this can be a concern. As long as these are individual stocks and not mutual funds you may be able to use a trading strategy to defer taxes temporarily. This is called “short against the box”. Let’s assume you own some stock in Apple. You can contact your brokerage firm and have them complete a short sale on the precise number of shares of Apple that you own without selling your shares. This guarantees that you cannot see a gain or a loss until you close out one of these positions. You have essentially created a cash position for an emergency and then realize the tax hit the following tax year in which you're unemployed status will likely produce a much smaller liability. This strategy cannot be implemented with mutual fund holdings.

Home Loan…You generally want to avoid borrowing more against your home. However if there is an outstanding loan against the home, call them to explain the situation and get in front of it with the lender. Years ago in this situation banks would re-negotiate temporary terms with you to make a lower payment and account for the difference when you return to work. You would pay interest charges but could do this without impairing your credit or incurring refinancing costs. Today there are numerous Federal programs and regulations that have greatly complicated this. There are modification programs that the bank can discuss with you. However qualifying takes time, and as result of the parameters the Federal Gov’t has laid out, they are not as free to simply negotiate a personalized plan. Yet most financial institutions have a department specifically for this purpose. It is not necessary to obtain the services of a 3^rd party to do this for you.

The best course of action is to always prepare for these types of emergencies in advance. And in reality all forms of financial planning are best addressed on an ad hoc basis. We each have assets that were bought at different times with different tax liabilities. It’s important to take a good accounting of these items and then find the most tax efficient and cost effective course of action to get yourself back on your feet.