John, who decided to go to medical school and become a physician in his mid-30s, still has $100,000 in student debt at 5 percent. This isn’t a terrible interest rate, but the money John has to pay monthly is preventing him from putting more funds into his other investments.
Fortunately, in addition to putting money into his IRA, John has a $250,000 taxable portfolio and finds a firm willing to give him a $100,000 loan at just 3 percent
interest with no amortization if he pledges his taxable assets. John does so, and instead of having a $417 a month payment, he now has a $250 a month payment.
More importantly, there is no required monthly payment, so he is able to much more effectively put away money in his various investment and retirement vehicles.7
In this chapter we discussed the importance of getting your numbers right. Focus on the
bottom line, after-tax amount of income that you need to generate. From there,
remember my grandmother and consider whether your distribution rates will change over time. The higher your net worth, the more they may actually fall over time. We then
looked at distribution rates that you may want to conservatively consider. If you need a higher distribution rate, you either have to take risk by reaching for a higher return or consider a lower-risk portfolio with debt to potentially achieve the same result.
AHAS! ADVISOR HIGHLIGHT ANSWERS
Question #1: What rate of return should you target relative to your client’s cost of debt?
Answer #1: A finance guy, a CFO, and I got together and debated this question (yes, I lead a fun and exotic life). I went first and said that I would want to capture a
spread of 2 percent, meaning if I am taking risk I want to get paid for it. So if my cost of debt is 3 percent, I would like to shoot for a rate of return of at least 5 percent. The finance guy said that all things being equal, if you knew you had the exact same rate of return, you would take the liquidity all day. The CFO told us it was fun to watch us have this debate but that we were both idiots. He explained you would take a
negative spread and that companies do it every day.
From his perspective, the value of liquidity, flexibility, and survivability are so
valuable that you should of course be willing to pay for them. The goal is to narrow the spread, but his point was that if you are paying 2 to 3 percent after taxes on your debt and earning 0 to 2 percent, you might take that trade for up to $1 million or more versus having it tied up in an illiquid asset such as a house. $1 million liquid assets and $1 million in debt versus $1 million in a house is a completely different liquidity situation in a time of distress.
There isn’t a right answer here but rather an important topic to debate.
Customization is necessary for each individual. But I see now that my answer was wrong. The finance guy was closer than I was, and in my opinion the CFO was right.
It’s important that professionals stay open-minded and receptive to learning.
The concepts of liquidity, flexibility, survivability, perspective, and leverage are, frankly, boring for many clients—and who cares about this stuff in bull markets?
Well, let me tell you, they matter considerably in bad times. As their professional advisor, it is essential that you consider each of these carefully with respect to each client’s individual situation.8
Notes
1. Ernie J. Zelinski, How to Retire Happy, Wild, and Free: Retirement Wisdom That You Won’t Get from Your Financial Advisor (Edmonton, Canada: Visions International
Publishing, 2014), 28–29.
2. This topic was discussed at a conference, First Clearing Financial Advisor’s Forum, hosted by First Clearing Correspondent Services, a division of First Clearing, LLC, in September 2014, in St. Louis, Missouri.
3. Trinity study, http://afcpe.org/assets/pdf/vol1014.pdf.
4. Thomas J. Anderson, The Value of Debt: How to Manage Both Sides of a Balance Sheet to Maximize Wealth (Hoboken, NJ: John Wiley & Sons, 2013), p. 77.
5.
6. See Robert Farrington, “Struggling with Student Loan Debt Over Age 50,”
www.forbes.com/sites/robertfarrington/2014/08/20/struggling-with-student-loan- debt-over-age-50/.
7. Case studies are for educational and illustrative purposes only. They assume eligible assets and that funds are available on the facility. All client situations are unique, and all loans are subject to eligibility and approval by the lender. A lender may deny an advance on an ABLF, preventing the scenarios. Pledging assets reduces and may eliminate liquidity. A market correction could impact market values and/or security eligibility, which could impact the facility size and/or trigger a margin call and/or forced liquidations of assets. See complete disclosures and risks to using an ABLF in Appendix F.
8. Author’s Note: The information in this chapter is to be considered in a holistic way as a part of the book and not to be considered on a stand-alone basis. This includes, but is not limited to, the discussion of risks of each of these ideas as well as all of the
disclaimers throughout the book. The material is presented with a goal of encouraging thoughtful conversation and rigorous debate on the risks and potential benefits of the concepts between you and your advisors based on your unique situation, risk
tolerance, and goals.
Chapter 5
The Power of DebtTM Meets Our Ridiculous Tax Code
$5.5 Million Net Worth, $240,000 Income, and $4,000 in Taxes!
The world’s largest cat weighs more than 900 pounds. Hercules is a “liger,” a cross between a lion and a tiger. You can see a picture of him in Figure 5.1. This particular kitty’s size is due to “hybrid vigor,” defined as “increased vigor or other superior qualities arising from the crossbreeding of genetically different plants or animals.”1 This chapter will demonstrate some surprising, possibly shocking attributes of another kind of hybrid vigor, the kind that results from making use of a retirement strategy that involves both sides of your balance sheet.
Figure 5.1 Hercules the “Liger”
Source:© Splash News/Corbis2
During retirement, finding ways of bringing in money—cash flow—that comes from both your assets and your debts can produce a hybrid result that delivers a greater total
amount of incoming cash, is more resilient and tax efficient, and pretty much better for you in many ways. Another way of thinking about this is in terms of “synergy,” which is defined as “the benefit that results when two or more agents work together to achieve something either one couldn’t have achieved on its own. It’s the concept of the whole being greater than the sum of its parts.”2
Put differently, some things have “emergent properties” that you could not have predicted merely from the underlying ingredients. If you mix up flour, water, yeast, and heat, you get something completely different and not found within any one of those ingredients:
bread. And if you create a proper mix of incoming cash flow both from selling down part of your portfolio, like your IRA or 401(k), and borrowing against another part of your portfolio through an asset-based portfolio loan, then an unexpected hybrid with
synergistic and emergent properties results—one that yields a nice amount of a different kind of “bread.”
A certain amount of math, figures, and tax calculations are a necessary part of this
chapter. I will make things understandable by presenting you necessary information in multiple ways, including the use of words, diagrams, and spreadsheets that will further reinforce the central concepts. Ultimately, what really counts is your own situation, and to get a thorough handle on your situation you should work with your own advisor to see if the ideas and practices make sense for you.
Some Brief Preliminaries: Income versus Incoming Money
Don’t let yourself fall into “empty.” Keep cash in your house. Keep gas in your tank.
Keep an extra roll of toilet paper squirreled away. Keep your phone charged.
—Gretchen Rubin
A few preliminary definitions are necessary here. The first concerns the definition of
“incoming money.” At the end of the day, when you are in retirement, the single most important resource—and a large determinant of your lifestyle—is the amount of money you will have available to you, month after month, in your banking or checking account.
As certified financial planner Mark Singer puts it:
The most important step is understanding your cash flow needs. Cash flow is the number one driver of a successful retirement. You could be worth millions of dollars, but if you are not able to generate the income needed to live the lifestyle you desire, then you will not have a successful retirement.3
There is no question that incoming money—cash flow, if you will—is of paramount
importance. The strategy demonstrated in this chapter involves creating incoming money in part by using a line of credit. Now, when you look at the IRS definition of “income,”
you will see that it includes a lot of things, including earned income as a wage, profits from stocks or real estate sales, stock dividends, lottery or gambling winnings, and even the cash value of bartered items. It does not include writing yourself a check from your portfolio line of credit. (The fact that this isn’t income is great news, because that means it is not taxed as income.)
To make it perfectly clear, since money from a line of credit is not income and therefore not taxable, I will refer to it as “incoming money” instead of income. The term “incoming money” does include all the other types of income listed above, such as dividends, money from stock sales, earned wages, and so on. Our focus, then, is on incoming money or retirement cash flow, not on income per se.
The Websters: A Tale That Taxes the Imagination
The hardest thing to understand in the world is the income tax.
—Albert Einstein
In The Value of Debt we presented the example of Mr. and Mrs. Webster. Because a lot of the details were in footnotes, I go through the Websters’ example a little more slowly
when I go around the country giving presentations on strategic debt philosophy and strategy. What I find is that the audience members’ jaws tend to drop as they grasp what I’m showing them and they wonder how it can really be possible.
Let’s take another look at the Websters’ scenario in a step-by-step fashion. As for how it could be possible, well, a lot of it is because of the U.S. Tax Code, which is more than 4 million words long and has thousands of changes made to it annually. The code is nearly incomprehensible and kind of crazy in many ways. But we’re not here to question the wisdom of the U.S. Tax Code but rather to find a way to work with it so that you can have the best possible retirement.