Unexpected expenses plague people in every stage of their lives. But they're most devastating to retirees on a fixed budget that has to last them an uncertain number of years. Even the best-laid retirement plans can be derailed by a health emergency, major home repair, or insurance claim.
If you're one of the unlucky few whose life has been turned upside down by an unexpected expense, the path forward isn't easy. Here are three things you need to do to weather the storm.
1. Use your emergency fund if you have one.
Everyone should have an emergency fund containing three to six months of living expenses to help cover unexpected costs so you don't have to borrow or fall behind on your payments. After you draw upon these funds as needed, you can replenish them in the months following.
But replenishing your emergency fund is trickier when you're retired because, unless you go back to work, the only source you have to draw from is your retirement savings. You could do this if your investments are doing well. You could also use tax refunds or money you take out for your required minimum distributions (RMDs). More on those below.
2. Understand the tax implications.
Your retirement savings are taxed differently depending on the account the money comes from. You don't owe any taxes on the initial contributions you made to a Roth IRA because you paid taxes on your contributions in the year you earned the money. But in some cases, you could owe taxes and penalties on earnings in your Roth account. Moreover, you haven't yet paid taxes on the funds in other types of retirement accounts, such as traditional IRAs and 401(k) accounts, so you must pay this when you withdraw the money. If you've retired early, then you'll also want to consider that there's also often a 10% penalty for withdrawing money before reaching age 59 1/2.
Paying for a large emergency out of your tax-deferred retirement savings could raise your tax bill significantly for the year, causing you to lose even more money when Uncle Sam asks for his cut. You can get around this by relying upon Roth savings to cover unexpected expenses or by using your emergency fund.
Emergencies aren't always bad for your taxes. If you have a medical bill that costs more than 10% of your adjusted gross income -- income minus tax deductions -- you can write this off on your tax return, reducing how much you owe for the year. Consult with a tax professional if you're unsure how your emergency expenses may affect your tax bill for the year, and adjust your retirement spending accordingly.
You have free articles remaining.
3. Reevaluate your retirement withdrawal strategy.
You may have to reduce your discretionary spending following an emergency to ensure you have enough money to cover your basic living expenses through the rest of your life. If possible, you could cut back on travel, dining out, and other nonessential costs until you've made enough room in your budget to accommodate the unexpected expense.
Larger emergencies may require a complete rethinking of your retirement withdrawal strategy. Whether you'd previously calculated your annual retirement withdrawals using the 4% rule, or based on required minimum distributions (RMDs), or something similar, run the numbers again based on your new, smaller retirement savings balance to determine how much you can safely afford to withdraw each year.
Retirees over 70 1/2 will also have to be mindful of RMDs. These are the government-mandated amounts that you must withdraw from retirement accounts other than Roth IRAs each year, unless you're still working and own less than 5% of the company you work for. You can calculate yours by dividing your total retirement account balance by the distribution period next to your age in this worksheet. You must withdraw at least this much from your savings each year or you'll pay a 50% penalty on the amount you should have withdrawn. But that doesn't mean you have to spend it all. Keep it in a savings account if you don't need it right away or put the extra toward your emergency fund.
Consult with a financial adviser if you're unsure how to adjust your retirement withdrawal strategy following your emergency. Choose a fee-only adviser who is a member of the National Association of Personal Financial Advisors (NAPFA) or a similar organization. Avoid advisers who earn commissions for recommending certain investment products since this could create a conflict of interest.
There's no way to completely insulate yourself against unplanned financial shocks. But by maintaining an emergency fund and reevaluating your tax liability and retirement withdrawal strategy following an unexpected expense, you can hopefully prevent your financial security from being threatened.
The $16,728 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,728 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.