How do I respond to a financial emergency?

Read time: 6 to 7 minutes

Sometimes it's hard enough to cover everyday expenses. Throw in car trouble, a burst pipe, or a job loss, and it can be hard to find the cash to weather the unexpected and then get back on track.

Here are some strategies to consider when you're dealing with a financial emergency.

Use your emergency fund

If you have an emergency fund, this is the time to use it. You’ve saved for this very reason. Once you're back on your feet, you can start building up your account again.

Having extra cash on hand can be a huge benefit. For proof, look no further than the COVID-19 pandemic. Many people suddenly lost their jobs or worked fewer hours—a reminder that you can't predict the future, but you can prepare for it.

Looking to start an emergency fund? Aim to save up to 3 to 6 months of living expenses. But everyone's situation is different, so read this article to see how much you might need in your emergency fund.

DO YOU HAVE A HEALTH SAVINGS ACCOUNT (HSA)?

Does your financial emergency include medical costs? If so, you may be able to use your HSA.

An HSA is a savings account outside of your workplace retirement plan where you can save money to pay for qualified medical costs now and in the future. If you participate in a high-deductible health plan at work, an HSA may be available to you. If you use the money for other purposes, you may have to pay income taxes and a hefty federal penalty tax.*

Read this article to learn more about HSAs.

*Taxes: You can only use your HSA for medical costs that are covered. Otherwise, you may have to pay income tax on the money you take out. And if you're under age 65, you may also face a 20% federal penalty tax.

Try to avoid using a credit card

Emergencies are never fun. Do you really want to make them worse by paying more than you have to?

Interest rates on credit cards can be high. And don't forget about potential late fees, the risk of going over your credit limit, and the fact that your credit score could take a hit if you don't make your payments on time.

You may be able to access or borrow money without using a credit card. You may also want to consult with a financial advisor. Will paying for the emergency mean you'll struggle to pay your monthly bills and existing debts? Consider reaching out to your credit card company, bank, or other creditors. They may be willing to help by setting up a payment plan or reducing interest rates. It never hurts to call and ask. Remember: They don't make money if you can't pay.

Just don't wait until you're late on payments. It's important to contact them early.

Consider a loan from your retirement plan

Many retirement plans allow you to borrow from your account. This means your retirement savings can help you out well before you retire.

Plan loans have some advantages, including:

You're borrowing from yourself, so you'll be paying yourself back, with interest.
You automatically begin to repay the loan with every paycheck.

Plan loans have some drawbacks too, including:

Borrowed money can't grow until you repay it.
If you leave your job and can't repay your loan, your balance may be considered a distribution, subject to income tax and, if you’re under age 59½, a 10% federal penalty tax.*

Keep these things in mind if you're considering a loan from your plan.

*If your plan allows, you may be able to continue making loan payments using electronic bank transfer. Or if you have a new employer, you may be able to roll your existing plan account and loan to your new plan.

As a last resort, consider a hardship withdrawal

Your retirement plan may let you take money from your account if you have an immediate financial need. This is called a hardship withdrawal. Unlike with a loan, you don't repay the withdrawal. But you will pay a penalty.

And there are rules about which expenses qualify. These are determined by federal regulations and your plan's rules. The most common expenses are:

The purchase of a primary residence.
Certain repairs to a primary residence.
Prevention of eviction or foreclosure.
College tuition.
Medical costs.
Funeral costs.
Costs related to a federally declared disaster.

Please note: You'll need to submit documentation proving your financial hardship. A withdrawal can only be approved for the amount shown on your documentation.

Know the costs

A hardship withdrawal is still subject to income taxes if you withdraw pre-tax money. If you're under age 59½, you'll also owe a 10% federal penalty tax.

That means you might end up with less than you think. Here's why. Say you take out $10,000. You could be looking at total taxes and penalties of $3,200 (if you're in the 22% tax bracket). This would leave you with only $6,800 to deal with your emergency.

The money you withdraw could eventually threaten your ability to reach your retirement goals. While $10,000 might seem like a small drop in the savings bucket, you’ll also miss out on years of compounding. Over 30 years, your balance could be reduced by as much as $57,000* more than if you hadn’t taken your money out.

That’s why it’s important to consider your other options first.

Whenever you invest, there’s a chance you could lose the money.

*Assumes a 6% annual return. This is an example only. It doesn’t represent a real investment, and the rate of return isn’t guaranteed. The account balance is before any taxes. It doesn’t reflect the 10% federal penalty tax you may have to pay if you take money out before age 59½.