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5 money mistakes in a bad economy

Making a blunder with your finances can make a downturn even worse. Here are tips for sidestepping the pitfalls in credit cards, investing, college costs and other areas.

By Bankrate.com

Consumers have plenty to worry about during a challenging economy, and making a wrong move in personal finances could make a bad situation worse.

Obtaining cash through credit cards, retirement plans and home equity could end up being a costly quick fix. And complacency over personal investments and looming college costs could lead to missed opportunities for keeping hard-earned dollars.

Here's how to avoid some common pitfalls during an economic downturn.

1. Living la vida Visa

One of the most common responses to a financial crisis, such as a job loss, is to continue spending with credit cards, says Gail Cunningham, a spokeswoman for the National Foundation for Credit Counseling.

"We're great spenders but lousy savers," Cunningham says. "We're a hopeful lot of people. We keep thinking that our ship is going to come in."

But the reality is that it typically takes a job seeker one month to replace $10,000 of lost income, she says. So a prospective employee should expect it will take five months to replace a $50,000-a-year job.

Rather than continue a lifestyle financed by credit cards -- and compounding debt in the process -- consumers should "circle the wagons" by figuring out where they spend their money, Cunningham says.

Just as calorie counters keep logs of each meal and snack, consumers should keep a meticulous watch on incidental purchases, including meals in restaurants, nights at the movies and gourmet cups of coffee. Think of it as an expense report to yourself.

"Nobody likes to do it, but you can do anything for 30 days," Cunningham says. "Tracking your spending is one of the most basic elements of financial stability."

Once consumers have a handle on spending, do they have to go cold turkey on all of the good life's trappings? Not necessarily.

Cunningham suggests that cutting back on some expenses is better than cutting them out.

Comb through cable bills, cell phone plans and other services for lower-cost alternatives. Folks who haven't watched HBO since the finale of "The Sopranos" or have never started a conversation with a text message may save a few bucks per month by dumping these options.

What to do:

  • Stop using credit cards.

  • Track monthly spending.

  • Cut down, but don't cut out, your lifestyle spending.

2. Invading your nest egg

Economic downturns have a way of drying up consumers' liquidity. Meanwhile, creditors only get thirstier. But as tapped-out consumers have fewer options to get cash, they may be tempted to withdraw from an individual retirement account or borrow from a 401k plan.

Taking cash out of a traditional IRA can lead to a double whammy of a 10% penalty and taxes of at least 25% if the individual is younger than 59 1/2, says Ira Marks, a certified financial planner in Lawrenceville, N.J.

For example, a couple with a combined yearly income of $100,000 who withdrew $25,000 would pay a $2,500 penalty, plus a tax of $6,250, for a total of $8,750, Marks says. State taxes could also be added.

Taxes and penalties would be more for a couple who earn more money. A couple who make $200,000 annually would pay $10,833 for the same $25,000 withdrawal, Marks says.

There are exceptions, such as if the withdrawal is made to pay for medical expenses, he adds.

Another caveat to note: If the money is replaced within 60 days, no taxes or penalties a levied -- good to know if you need a quick infusion of cash for a college tuition payment before a commission check comes in, for example.

"But most people don't become aware of that until they are working with their tax preparers the following year," Marks says. By that time, the 60-day window to avoid losing money to taxes and the penalty has closed.

For a Roth IRA, a person younger than 59 1/2 who withdraws the earnings within the first five years of opening the account would pay the 10% penalty and taxes. There is no penalty or tax assessed when direct contributions (not including rollover contributions) to a Roth IRA are withdrawn.

People who may be leaving their jobs soon -- voluntarily or not -- may want to think twice before borrowing against a 401k plan. Once an employee leaves a company, the loan turns into a taxable withdrawal, triggering the federal government's 10% penalty, Marks says.

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What to do:

  • Consult a tax preparer or financial planner before tapping into retirement plans in order to understand all the associated costs.

  • In some cases, withdrawals from a traditional IRA can be subject to a federal 10% penalty and can be taxed. But an individual can avoid these costs if the withdrawal is paid back within 60 days.

  • Withdrawals from a Roth IRA can be subject to a 10% penalty, but there are no additional taxes.

  • Withdrawing from an IRA should be the last resort because it diminishes money set aside for retirement. However, if faced with a catastrophe, such as foreclosure on a home, it may be a justifiable move.

Continued: Paying for college

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