Download Comparing Different Asset Classes for Banking

Comparing Different Asset
Classes for Banking
949-288-6650 | [email protected]
Strategy
Tax-Deferred Growth
Tax-Free Distributions *
Annual Guaranteed Growth
Annual Growth Potential
Low Volatility
Funding Flexibility
High Contribution Limit
Loan to Value Capacity
Flexible Loan Provisions
Creditor Protection **
Deductible Contributions
Additional Death Benefit
Whole Life
Legend
Favorable
Less Favorable
Unfavorable
Index UL
Stocks/ETFs Taxable Bonds Muni Bonds
401(k)
Savings/CDs
* Assumes that distributons are policy loans or withdrawals taken only up to basis. This also
assumes that some portion if the original policy amount stays in force and a death check is
delivered to beneficiaries even if token amount.
** Creditor protection stipulations vary by state and should be verified by qualified legal council.
Any intent to defraud creditors nullifies said protection.
Whole Life Insurance:
Our Thouths:
This type of permanent life insurance policy is most often the recommended banking mechanism
of choice due to the fact that it has the strongest guarantees for growth, death benefit, and premium
commitment. That said, those guarantees come with the tradeoff of having less funding flexibility than
you would with other asset classes since it requires at least some sort of minimum annual premium
payment during the funding phase, whereas other types of insurance vehicles and asset classes do
not. However, this annual premium requirement can be minimized through proper policy design by
a knowledgeable agent. Even though Whole Life policies offer steady guaranteed growth as well as
historically consistent non-guaranteed annual dividends payments, there is less potential for upside
than you would have in the stock market or other types of insurance policies. It is not uncommon for
the insurance company to lend against somewhere between 80-95% of your cash surrender value at
any time for any reason. Borrowing is not a taxable event, nor is any interest crediting or dividends
reinvested into the policy as long as the policy stays in force. Also, tax free withdrawals (without any
loans) can also be made from the policy up to one’s basis.
We find that clients who are very conservative, risk averse, and have steady cash flow gravitate
toward this product type. They want a consistent stable base of growing funds they can point to
each and every year even if it lags the stock market in strong bull markets. It is the one asset class
that is contractually guaranteed to grow no matter what, as well as being immune from taxation if
designed and utilized properly. Although, it may be possible at times to acquire lower loan interest
rates from outside lenders, you can’t beat the flexibility of the contractual policy loan feature,
which is as flexible as you need it to be. You can pay principal and interest, interest only, float the
loan until a balloon payment can be made, or let the death benefit ultimately pay off the loan when
you die. Since you can often access around 90% of your cash surrender value, this asset class can
give you more capacity in case of an emergency or a time-sensitive wealth building opportunity.
Indexed Universal Life Insurance:
Our Thouths:
This type of permanent life insurance policy offers strong upside growth potential with limited risks
as long as the policy is funded heavily in the first 5-10 years. Often, no payments will be due later if
an IUL policy is funded in this manner. This type of policy also offers maximum funding flexibility
since no premiums are due as long as you have enough equity to support the charges. You can choose
from a number of index crediting strategies that track popular indexes like the S&P 500 or the Euro
Stoxx 50. In good index years you can capture significantly higher crediting rates than what you
can earn with whole life or bonds in the current environment. In years of good market performance
you may receive double-digit index crediting, while in years of bad market performance you run the
risk of receiving 0%, which is the contractual floor for your interest crediting. Having the potential
for competitive upside potential while still maintaining contractual downside protection all within
a tax-exempt environment is unique to this product. Certain carriers will also lock in your cost to
borrow against the policy with contractually-locked loan rates or ranges, which can be attractive if one
foresees utilizing the policy loan feature often.
We find that clients who gravitate toward this product type are really intent on either having greater
upside potential and/or maximum premium flexibility. They may have unpredictable cash flows
and may need to completely skip entire years of premium. These clients must also be fine with
knowing that they may not receive policy crediting for multiple years during recessions. However,
with a contractually locked loan feature they also have the potential to earn multiple years of
positive interest arbitrage (indexed crediting over the policy loan interest rate) when borrowing
for purchases or other wealth building efforts. Although pundits speak of the long-term risks of
the policy sustaining itself, this risk can be greatly mitigated by funding the policy heavily early on
(paying all premiums within 5-10 years). If you are not prepared to do this, then IUL will not be the
best asset class for building your own banking mechanism.
Stocks and Stock-based ETFs:
Our Thouths:
Individual stocks and ETFs (funds that are comprised of various individual stocks) will work very
similarly in the context of banking. To clarify though, individual stocks represent equity ownership in
individual companies and Stock-Based ETF’s represent ownership in a collection of companies usually from one major market index, sector, or country. There is unlimited potential for upside, but obviously there is also the potential for large losses (not limited to your entire investment if you intend
to borrow against these assets). Since this asset class can lose value quickly, brokerage houses will
typically only lend against 50% of your total equity in the account. Thankfully, borrowing against your
stocks is not a taxable event, nor will any tax be due on any of the underlying equity investments until
they are sold for a gain. Capital gains and Dividend distributions may be taxed at a more favorable tax
rate as long as the underlying equity investments are held for the required time period.
Taking a margin loan against stocks or ETFs can definitely work to build your own bank with both
functionally and from a theoretical standpoint. However, we consider this to be a risky proposition.
If at any point your equity values fall below certain thresholds, you will be required to sell the
underlying investments at a loss or contribute additional capital to maintain the investments. Also,
some of the best times to use your banking mechanism is to acquire assets during times of economic
instability when everything else is down. Ideally, your bank would be built from a non-correlating
asset class and not something that will also trend downward when buying opportunities present
themselves in the marketplace. Even though you have unlimited upside potential when times are
good, remember that even the most favorable tax rates attributed to these assets can mean eroding
somewhere between 15%-35% of your gain depending on your income level and tax home.
Corporate/High-Yield/Government/International Bonds and Taxable
Bond ETFs:
Our Thouths:
Individual bonds and ETFs that are comprised of various bonds will work very similarly in the context
of banking. To clarify though, individual bonds are a debt security where the owner has essentially
lent money to the company or country that issued that particular bond security. A Bond ETF
represents ownership in a collection of these debt securities from different issuers. As interest rates
rise and/or during times of economic pessimism the underlying value of these securities may fall. As
interest rates fall and/or during times of economic optimism the underlying value of these securities
may rise. Typically, brokerage houses will only lend against 50% of your total equity in the account
since these assets can lose value quickly. Borrowing is not a taxable event, nor will any tax be due on
any of the underlying debt securities until they are sold for a gain. Also, interest earned from these
types of bonds is typically taxed at a taxpayer’s highest marginal rate.
We are very concerned about the amount of downside risk with bonds since it is only a matter of
time until interest rates rise. When rates do rise, your bond portfolio value may fall which means
you risk having to sell the securities for a loss or contribute additional capital to maintain the
investments. Corporate and High Yield bonds also tend to lose value as the stock market falls since
people are worried that their principal won’t get paid by the issuing companies, which accentuates
the same risk. On top of that, interest earned from any of these bonds is taxable at one’s highest
marginal bracket. That means that your yield is essentially going to get chopped by a quarter, a
third, or even in half depending on your income level and tax home. All of these factors simply make
these taxable bonds a non-starter as your banking engine.
Municipal Bonds and Muni ETFs:
Our Thouths:
Individual muni bonds and Muni ETFs will work very similarly in the context of borrowing against
these types of assets. To clarify though, an individual municipal bonds is a debt security where the
owner has essentially lent money to the issuing municipality. A Muni ETF represents ownership in a
collection of these securities usually from one state’s municipalities or a group of municipalities with
similar risk characteristics. As interest rates rise and/or during times of economic pessimism the
underlying value of these securities can fall. As interest rates fall and/or during times of economic
optimism the underlying value of these securities can rise. Typically brokerage houses will only lend
against 50% of your total equity in the account since these assets can lose value. Borrowing is not a
taxable event, nor will any tax be due on any of the underlying debt securities until they are sold for
a gain. Interest from municipal bonds is earned tax free from federal tax and often state tax so long
as the issuing state is also the owner’s tax home. However, interest earned from municipal bonds is
usually lower than their corporate bond counterparts.
Since the interest you earn on muni bonds is tax free, it is typically a lower interest rate relative to
other bonds. Usually only taxpayers near the highest brackets reap strong rewards from these lower
yields. Although these securities tend to have lower volatility in times of economic uncertainty, we
are still very much concerned about the effect that future higher interest rates will have on these
bonds. Even if the bondholder does not lose any principal value by holding the bond all the way to
maturity (often over 10 years), if interest rates rise they will be locked into the lower interest rate
that the bond was issued at causing a lost opportunity cost.
401(k) loan:
Our Thouths:
Not all 401(k) plans allow for loans, but many do if the provisions are written into the plan document.
The plan administrator usually charges an annual fee to process and track the loan. Loans are
typically limited to half of your vested account balance or $50,000, whichever is lower. Although
401(k) loan interest rates can often be below market rates, and the interest you pay actually goes right
back into your 401(k) account, you actually create a small double tax for yourself by borrowing this
way. You see, the interest on a 401(k) loan must be paid back with after-tax dollars you earn, but you
are sending those after-tax dollars back into a pre-tax environment where they will potentially grow
and be taxed again someday. Under most circumstances, both principal and interest from a 401(k)
loan must be paid back within 5 years or else it is deemed an early distribution from the plan. If the
loan isn’t paid back in time you will probably incur taxes due on the unpaid loan balance at ordinary
income rates as well as the 10% tax penalty for an early withdrawal. Someone leaving their job for any
reason can also trigger the same consequences if the loan isn’t paid back shortly after separation from
service. A 401(k) account will typically own both stock and bond investments so many of the same
risks we already discussed above may apply.
In lieu of having no other options, a 401(k) loan can be a viable source for short term liquidity
needs when someone foresees stable employment and enough steady cash flow to service the loan
over the following 5 years. The double tax created on the interest payments can often be more
favorable than the higher interest rates associated with traditional borrowing options. However,
continuing to compound this double tax over a long period of time can result in a lot of additional
tax paid in retirement. This comes at a time when a lot of your deductions have likely vanished
and you need the money the most since you are no longer working. It’s also worth noting that your
borrowing capacity will always be capped at the lessor of $50,000 or half of your account balance.
So it’s likely that other asset classes will be necessary anyway to build any kind of substantial
banking mechanism. When clients have this capability in their 401(k) plan we recommend they
keep it in the back of their mind as a last resort emergency bucket or bridge loan possibility.
Savings Accounts and CDs:
Banks will often gladly lend against these types of deposits you make with their institution. Since
there is no risk of loss, many banks lend closer to their full value unlike the riskier investments which
are often limited to loans at half their value. Needless to say, the spread between how much interest
banks are paying on these deposits (a rate of return that likely starts with a dot) will be much lower
than the rate they will offer to lend at. Although there is little or no risk involved, the interest crediting
rates are paltry and have often lagged the inflation rate in most years. What interest is earned is
taxable at one’s highest marginal bracket. Often depositors will only do this to repair credit scores.
Do we even need to go there? You may as well use a mattress since you really have no shot to get ahead
using this asset class.
949-288-6650 | BankingTruths.com | [email protected]
Characterizations are subjective so be sure to first consult with qualified tax and legal professionals before
implementing any strategy or product discussed herein. Information presented is for educational purposes only
and does not intend to make an offer or solicitation for the sale or purchase of any specific securities product,
service, or investment strategy.