Imagine you had to go without the income from your job for a month…or even six months. Do you see yourself losing your apartment and eating ramen on a friend’s couch? Could you subsist those months simply by tightening your belt and forgoing anything that isn’t an absolute necessity? Or could you live a relatively normal existence simply by postponing any extravagant expenses?
Whatever situation you’re in right now, I think you’d agree that it would be ideal to be able to survive a few lean months without moving or selling most of your possessions.
Even if you hope it will never happen to you, we all know someone who has lost their job due to downsizing, mergers, or poor performance. State unemployment benefits may help, but they don’t last forever. And you may not be eligible if you get fired for cause.
But there are also times in which you may actually want to go without an income for a period. Maternity or paternity leave is the big one that comes to mind. In the U.S., unless you’re extremely fortunate to work for an employer that provides paid parental leave, you can expect that time to be unpaid. Or, you may simply want to take a multi-week sabbatical from work or leave a soul-sucking job and take time to figure out your next move.
These situations—unpaid parental leave, a sabbatical, or being able to tell a horrible boss to F-off—are unimaginable if you haven’t yet built an appropriate financial foundation. With even a modest one, however, you’ll not only be able to endure a period of time without income, but even enjoy it by adjusting your expenses as much as necessary.
So what kind of financial foundation do you need? And, if you do need to draw upon it, what’s the best way to do it.
It all starts with the emergency fund
This situation is exactly the reason I (and most other financial writers) stress the importance of having a cash emergency fund ahead of almost every other goal, save paying off ultrahigh-interest debt.
Rainy day savings can come in handy in a variety of situations like when something breaks, be it your car, washing machine, or a bone. But the prospect of losing your income is the single biggest reason to have an emergency fund. Although never ideal, you’ll probably be OK even if you have to charge a car repair or hospital bill to a credit card and pay it off over several months. But relying on borrowed money to get through an extended period without income is a recipe for financial disaster. At best, it will double or triple the impact of the lost income on your finances. At worst, it could put you in a hole that will seem impossible to escape.
The ability to deal with job loss is why I don’t simply recommend saving a fixed dollar amount ($1,000, $5,000, etc.) as an emergency fund, rather an amount of money equal to several months of actual expenses. Three months’ worth of expenses is your minimum target, but you should eventually aim to have six months’ worth of living expenses saved as an emergency fund. Try our emergency fund calculator here.
A side income will help, too
If there’s another topic I stress nearly as much as having an emergency fund, it’s having a second source of income. That could be an income-producing rental property or investment income from stocks and bonds, but the younger you are, the more likely it is that will mean a side hustle.
Even a low-wage part-time job will go along way to smoothing over a gap in your primary income, but you’ll be even better off if it’s a job, freelance gig, or business in which you can pull a lever to work more and earn more when you need it.
Of course, if you’re taking time off from work intentionally, whether as a sabbatical or for parental or health reasons, you might not want to work at all. If you have a second stream of income that’s passive, like rental property or investment income, more power to you. That’s less common, of course, and that’s OK. It just means you’ll have to rely more on your emergency fund and other options.
Other sources of cash
If you don’t have enough of an emergency fund or you expect your absence will completely draw down your emergency savings, you can look to other savings and investment accounts, but this is where you’ll want to be extremely careful.
In general, there are three types of accounts you might consider tapping to cover expenses when you’re without income:
- Other cash savings accounts (cash savings accounts designed for a specific goal)
- Taxable investment accounts
- Retirement accounts (IRAs, 401ks, etc.)
Other cash savings accounts
Perhaps you have some money set aside for a vacation, a new car, or a down payment on a home. Of course, you never want to touch savings set aside for a concrete goal until you’re ready to withdraw the cash explicitly for that goal, but a forced period without income is a worthy exception. Assuming your money is in a liquid account and can be withdrawn penalty-free, this would be the first place to look for additional resources.
Taxable investment accounts
Let’s assume, however, that your additional savings are in stocks and bonds, ETFs, or mutual funds that you hold within a taxable brokerage account (in other words, not in an IRA or other retirement account). Although you can sell these investments and withdraw cash without penalty, doing so may have negative consequences.
The first is that you may be selling the investment a lot sooner than you anticipated, and possibly at a loss. You want to try to hold investment as long as possible to take advantage of long-term growth and compounding, so it’s always best to avoid being forced into a sale.
On the other hand, if you sell these investments at a profit, you’ll owe income taxes on any capital gains (the difference between what you sold the investment for and what you paid for it). That tax bite will be larger if you’ve held the investment for less than a year, so always sell investments you’ve held for a year or longer before selling ones you’ve held a year or less.
One option you have with investment accounts is to only withdraw dividends. Many investments pay dividends on a monthly, quarterly, or annual basis. These dividends are either automatically reinvested or distributed to you as cash. That’s something you can easily change by calling your brokerage. Some dividends are taxable, but spending dividends first can save you from selling shares unnecessarily. Unfortunately, annual dividends are a small percentage of your total investment, so they won’t add up to much unless you have a good size portfolio.
If you really need the money, you may need to accept these consequences and liquidated investments, but you can see why it’s a less desirable option than using cash on hand.
Making an early withdrawal from any retirement account is such a bad idea (whether it’s a 401k, 403b, IRA, or other tax-advantaged account) that I hesitate to even mention it. Unfortunately, however, it’s one of the first place many people turn when they need cash, so I want to clearly explain why it’s such a poor choice.
First of all, the IRS imposes an automatic 10 percent penalty on most early withdrawals from retirement accounts. If it’s a ‘traditional’ retirement account (in other words, not a Roth account), you’ll also owe income taxes on the entire withdrawal. So, depending on your state income tax rate, you’re looking at only being able to withdraw 60 or 70 cents on the dollar.
With Roth accounts, you’ll only owe income taxes on any earnings in your account, not the principal. That’s because you already paid taxes on the money you put into a Roth. But you may still owe the 10 percent penalty on all withdrawals. There are specific situations in which you can make early Roth withdrawals penalty-free, such as using up to $10,000 toward the purchase of your first home, but it’s still not a great idea.
That’s because an early withdrawal from a retirement account defeats the purpose of the accounts in the first place. You set money aside in those accounts for your financial security in later life. When you get older, you’ll need that money because you won’t want to work anymore or possibly won’t be able to work. The money in your retirement account is hopefully invested and will be compounding over many decades. That compounding will, hopefully, multiply your initial contributions many times over. Withdrawing those funds early sabotages all of that future growth, and your future self!
As I mentioned earlier, borrowing money to cover your expense during a prolonged period without income should be an absolute last resort. You want to be cautious taking on debt even when you have a healthy, stable income. Borrowing money without an income or when you’re not sure when your income will return is downright dangerous.
If you find yourself with no other options, however, bear in mind the following:
- Credit cards should never be your first choice to finance living expenses. The high-interest rates on credit cards and the fact they provide a revolving line of credit that you can use again and again makes them particularly likely to ensnare you in debt that you won’t be able to repay.
- A personal loan or, if you own your home, a home equity loan, may provide a lower interest rate and will come with fixed monthly payments that you can repay over a fixed number of years.
Finally, you may not be able to get approved for many credit products if you’ve already lost your income—many lenders will require proof of your employment. If your absence from work will be a planned one, you’ll have better luck securing a loan while you’re still working.
Managing your finances during an absence from work
Now that we’ve looked at all the potential funding sources for your absence, let’s talk about managing that money after your paycheck stops.
How much money will you need?
This can be a tricky question to answer if you’re unsure how long you’ll be out of work, but a bit easier if you know you’ll be out for eight weeks for a sabbatical or parental leave. In either case, it’s best to plan for the worst-case scenario and be pleasantly surprised if you get back to work sooner than expected.
If you’ve so far avoided the dreaded budget word, now there are no more excuses. You are absolutely going to need a clear picture of your expenses. Look at an entire year’s worth of bank and credit card statements to capture not just your expenses last month, but also expenses that are irregular or occur less frequently than monthly.
Look for easy cuts
We all have expenses that are clearly “nice-to-haves”. Maybe they’re premium TV channels or a quarterly Stitch Fix. Mercilessly cut or suspend these. Hopefully, this shouldn’t be too difficult for you because you can remind yourself it’s only temporary.
As long as your hiatus from work is temporary, you can suspend retirement savings contributions and other savings deposits. If you have student loans, you may also want to call and inquire about a temporary deferment. Keep in mind that interest will continue to accrue, so if you think you can still make your regularly scheduled payments, it’s best to do so.
Be realistic with everything else
There will be other expenses that you won’t be able to eliminate with an email or phone call, but suspect you’ll be able to reduce. Eating out is probably the biggest one. When times are good, we all go out and order out without much thought. And this creates some eye-popping numbers when we add up a months’ worth of receipts.
Chances are, you can cut a lot on your dining habits. Still, it’s hard to predict just how much. Be realistic here. Plan to cut back, but don’t tell yourself you’re going to go on a steady diet of cereal and PB&Js if you don’t mean it. At this stage, it’s better to overestimate your expenses than to underestimate and fall short of your required cash.
Don’t forget new expenses
Many older people approaching retirement expect they’ll spend less money when they stop working. Their kids will be grown, they won’t have to worry about commuting costs or workday lunches, and perhaps they’ll downsize their house. But they don’t take into account all the new ways they might want to spend money in retirement, mainly travel and leisure activates. In some cases, they might actually spend more money to fulfill the new lifestyle they want.
You may or may not have this problem, but it’s of particular concern if you’re taking time off to be home with a new baby. Babies are crazy expensive! You may have already budgeted for diapers and formulas, but four or five weeks in, you’ll be ready to buy anything that will help your baby sleep so you can, too. Expect lots of unexpected expenses here.
Figure out where the money’s coming from
Now, determine how you’ll fund your needs, on a monthly basis, by looking at available sources, in the following order:
- Income from unemployment, disability insurance, side-hustles, or investments (including interest earned on your savings account(s), however paltry.
- Emergency fund withdrawals
- Income from other savings accounts
- Withdrawals from taxable investments
- Other sources of last resort (loans, retirement accounts)
At the risk of sounding like a broken record, you absolutely want to avoid the last group of resources. If it means cutting a planned work absence short, that’s the better choice.
Plan your withdrawals
Figure out the date and amount of your final paycheck and work forward from there. If you’re paid a regular amount every two weeks and have been competently managing your cash flow, it will be easiest to replicate that paycheck by scheduling automatic transfers between your emergency fund and checking account on your regular payday.
Don’t transfer the money all at once, as doing so will forfeit a small amount of interest that the money will earn while it stays in your savings account.
When it comes to selling investments, plan your sale a few business days before you’ll need the cash in your bank account, as you’ll need time both for the trade to clear and the money to be transferred to your bank. Don’t forget to take into account stock market holidays. Finally, don’t try to time the market. Simply calendar your withdrawal dates.
Take into account the trading costs of selling your shares. If the overall amount of money you need to liquidate is small, you might want to sell all the shares at once so you’ll only pay one trade commission. When the amount is larger, you might sell in batches in the hope of capturing additional gains. If there’s no trading commission, as in the case of a fee-free ETF or directly-purchased mutual fund, only sell as much as you need on any given date.
Save a couple of weeks of paid vacation each year, most of us will spend several decades of our life working day in, day out. Time off from your job—whether planned or not—can be a delightful opportunity to enjoy life outside of the rat race…if you’re financially prepared.
If not, the stress of making ends meet may very well overshadow what could otherwise be a pleasant experience. To avoid that, make saving a healthy emergency fund a priority and have a plan in place for managing your money during an absence from work that will allow you to get on with life instead of worrying about cash flow.