Had a financial planning session with some relatives

[CoachKandSportsguy]

The scenario:

They needed a small amount of money to improve the second home.
Small meaning $0-50K, exact amount uncertain. Lets use $50K for simple back of the envelope calculations

They have a substantial IRA, and live well on pensions and IRA withdrawals.

I recommended taking the amount out of the IRA.

They consulted their financial advisor, his advice was to take out a home equity line of credit. So they proceeded down that road. Cost of interest is 7%

I asked how the financial advisor was compensated. The reply was "he gets a percentage of assets under management" The advisor told them that taking money out of the IRA would require taking out the amount plus a *huge* amount for taxes."

So here is the financial trade off with simple math:

Take out $50K from IRA, plus 22% for taxes = about $61K, est $11K for taxes

vs

Take out $50K, pay about $3,500 per year in interest. After 3 years, the interest payments are approximately $10,500. The interest qualifies for tax deductibility due to loan against the property for upgrades. The interest can only be deducted if the filer itemizes, which the couple does not. Therefore the interest is not tax deductible.

Conclusion:
Keeping the home equity loan costs more in interest if the loan is held for more than three years versus the one time tax payment. The relatives did not figure that part of the equation because they trusted their financial advisor to give them unbiased, fiduciary advice.

The money manager convinced the couple to avoid removing money from his paycheck using the fear of huge taxes. . without being specific about the trade off.

Remember Charlie Munger's quip:
"Show me the incentive plan and I will show you the resulting behavior"

Never fear taxes, just remember to understand and remember to use taxes in your financial decision.

good luck out there, its a financial jungle where everyone is looking at you for a meal

[retiredguy123]

I agree. I would add that the 7 percent interest is an additional payment that never needs to be paid if you don't borrow money. But, taking an IRA distribution and paying the tax is just paying taxes that you would eventually need to pay at some future time anyway.

[JohnN]

So, the financial advisor is advising in his/her interests. Interesting, not surprising.
Reminds me of our government.

[Caymus]

An unknown is the growth of the IRA in the 3 years.

[CarlR33]

Also you assume the extra 50K will not put them in the 24 percent tax bracket. Good points as each persons situation is different and the advisor was probably too lazy to do the actual math. I know banks are getting more transparent with their interest tables so it’s right there in front of you.

[Plinker]

Another reason to NEVER pay asset under management (AUM) fees to a financial advisor. Exception would be very low fees charged by Vanguard (0.3%) and others if you desire advice. Their advisor needs to look up the definition of “fiduciary “.

[Altavia]

Also you assume the extra 50K will not put them in the 24 percent tax bracket. Good points as each persons situation is different and the advisor was probably too lazy to do the actual math. I know banks are getting more transparent with their interest tables so it’s right there in front of you.


I'm sure the OP knows but adding also need to take IRMAA and RMD's into consideration.

Thanks to inflation, I'm fairly confident we'll end up paying more taxes on our 401K funds than we would have putting that money into a Roth or after tax account.

[manaboutown]

Too, the market is at or very near its high so perhaps a good time to harvest some gains as Buffett has done. Methinks the FA is very fond of his AUM fee and wants to keep it as large as possible.

[thelegges]

Our financial guy suggested we take money from our cash account this year, instead of using any of our zero balance equity accounts on our homes. Maybe a new financial guy is in order

[jimhoward]

The 50K in the IRA would probably appreciate over the coming three years, so that estimated appreciation has to be credited (after accounting for future taxes) against the interest expense on the HELOC.

On the other hand the taxes on the IRA will at some point need to be paid regardless of whether or not they withdraw the money now. That tax expense is postponed, but not avoided, by funding the home improvement with a HELOC.

[CoachKandSportsguy]

The 50K in the IRA would probably appreciate over the coming three years, so that estimated appreciation has to be credited (after accounting for future taxes) against the interest expense on the HELOC.

On the other hand the taxes on the IRA will at some point need to be paid regardless of whether or not they withdraw the money now. That tax expense is postponed, but not avoided, by funding the home improvement with a HELOC.

The point is about the cost of money being used, nothing else. The home improvement has to be done, and there isn't a high enough balance in the taxable bank/investment account. So you pick one or the other,

The cost of money from an IRA is one time fixed.
The cost of money of a HEloan is for as long as you have a balance, plus there is a cost of application.
The incremental tax rate is 22% and there is no IRMMA threat.

If the cost of a home equity loan is 7% and the average stock market gain is 8%, but is barbell shaped, there's not alot of difference between the two on average, but a lot depending upon the year.

Given GDP is negative,
Given that the dollar is falling,
given that container shipments from the far east are still falling
given the BB is an interest rate payment block buster,

I would err on the side of caution and pay the one time tax burden
versus assuming the stock market will continue huge annual gains.
So far this year, the market return is very low for the season YTD period.

good luck in your financial assumptions.

[Tomptomp]

One must also consider the “opportunity lost” when the 50gs is taken from the retirement account. $50,000 @ 5% interest over three years, for example, would earn an uncompounded $7500.

[MandoMan]

The scenario:

They needed a small amount of money to improve the second home.
Small meaning $0-50K, exact amount uncertain. Lets use $50K for simple back of the envelope calculations

They have a substantial IRA, and live well on pensions and IRA withdrawals.

I recommended taking the amount out of the IRA.

They consulted their financial advisor, his advice was to take out a home equity line of credit. So they proceeded down that road. Cost of interest is 7%

I asked how the financial advisor was compensated. The reply was "he gets a percentage of assets under management" The advisor told them that taking money out of the IRA would require taking out the amount plus a *huge* amount for taxes."

So here is the financial trade off with simple math:

Take out $50K from IRA, plus 22% for taxes = about $61K, est $11K for taxes

vs

Take out $50K, pay about $3,500 per year in interest. After 3 years, the interest payments are approximately $10,500. The interest qualifies for tax deductibility due to loan against the property for upgrades. The interest can only be deducted if the filer itemizes, which the couple does not. Therefore the interest is not tax deductible.

Conclusion:
Keeping the home equity loan costs more in interest if the loan is held for more than three years versus the one time tax payment. The relatives did not figure that part of the equation because they trusted their financial advisor to give them unbiased, fiduciary advice.

The money manager convinced the couple to avoid removing money from his paycheck using the fear of huge taxes. . without being specific about the trade off.

Remember Charlie Munger's quip:
"Show me the incentive plan and I will show you the resulting behavior"

Never fear taxes, just remember to understand and remember to use taxes in your financial decision.

good luck out there, its a financial jungle where everyone is looking at you for a meal

You are right. You might also ask if your relatives are also taking money out of their IRA. If they are still working, I’d say don’t touch the IRA. However, I live on Social Security and my mutual funds. I receive money every month from my mutual funds. The company takes 20% of that and sends it to the IRS. Some of it I may get back. If I’ve already paid 20% tax on what came from my ITA, and then I use part of that every month to pay off a home equity loan at 7%, that changes the equation.

[RoboVil]

One of the other costs to consider is if taking the money out of your IRA, and thus increasing your income for that year, will result in paying higher Medicare premiums, that is, the IRMAA costs. So, it may ultimately cost more if you take it out of an IRA. If the financial advisor is charging 2% on assets under management, then that would correspond to a $1000 annually for $50,000 AUM, the other cost to consider if taking out a loan and leaving the money in the IRA.

[rsmurano]

Both bad options. You also didn’t state that to get a heloc there are charges up front, appraisal for 1.
1st observation, why would anybody have to ask an advisor to do this kind of thing? 2nd, the advisor has a business plan to make as much money as possible off you while your business plan is to pay less or make as much money for me as possible. 2 conflicting plans, and the advisor will always win.

For this small amount, or for buying a house before yours sells, get a secured loan thru your broker, interest only, no impact to your investing options. I’ve done this for almost 20 years. When building a new house, I was the bank for draws and when I sold my house after we moved into the new house, I paid off the secured loan. You know how much loan fees are for building a home? You have a builders loan then you have a regular home loan after the house is completed. I was saving almost 5% in fees for being the bank instead of getting loans. You have a checkbook and you can write a check for a new house, a new Porsche, then have up to 10 years to pay off the interest only loan, or pay it off when you get home from the car dealer or closing company.

[BrianNotFromNYC]

You leave out some important information. If they have substantial pensions and mandatory RMD, it's possible this 50K increase in income will put them into a higher tax bracket and possibly double their Medicare cost for a full year due to IRMA. Perhaps another solution is to more carefully see what their tax situation is, and do the HELOC, and pay it down annually with IRA withdrawals, staying under a tax jump.

[jasamy2]

Thank you for breaking it down so we can understand. Now can you help with rolling over a traditional IRA to a Roth? 😁. Worth paying the taxes up front now or later?

The scenario:

They needed a small amount of money to improve the second home.
Small meaning $0-50K, exact amount uncertain. Lets use $50K for simple back of the envelope calculations

They have a substantial IRA, and live well on pensions and IRA withdrawals.

I recommended taking the amount out of the IRA.

They consulted their financial advisor, his advice was to take out a home equity line of credit. So they proceeded down that road. Cost of interest is 7%

I asked how the financial advisor was compensated. The reply was "he gets a percentage of assets under management" The advisor told them that taking money out of the IRA would require taking out the amount plus a *huge* amount for taxes."

So here is the financial trade off with simple math:

Take out $50K from IRA, plus 22% for taxes = about $61K, est $11K for taxes

vs

Take out $50K, pay about $3,500 per year in interest. After 3 years, the interest payments are approximately $10,500. The interest qualifies for tax deductibility due to loan against the property for upgrades. The interest can only be deducted if the filer itemizes, which the couple does not. Therefore the interest is not tax deductible.

Conclusion:
Keeping the home equity loan costs more in interest if the loan is held for more than three years versus the one time tax payment. The relatives did not figure that part of the equation because they trusted their financial advisor to give them unbiased, fiduciary advice.

The money manager convinced the couple to avoid removing money from his paycheck using the fear of huge taxes. . without being specific about the trade off.

Remember Charlie Munger's quip:
"Show me the incentive plan and I will show you the resulting behavior"

Never fear taxes, just remember to understand and remember to use taxes in your financial decision.

good luck out there, its a financial jungle where everyone is looking at you for a meal

[Stu from NYC]

Thank you for breaking it down so we can understand. Now can you help with rolling over a traditional IRA to a Roth? 😁. Worth paying the taxes up front now or later?

To me the opportunity cost of converting to a Roth and have less money invested makes the answer no.

Not to mention the govt could decide they needed to partially tax the Roth. Still waiting to see how they will fix social security so benefits can be paid in full in the future.

[Pugchief]

Not to mention the govt could decide they needed to partially tax the Roth.

Ha. IMO, not if, but when people above certain thresholds (which will, of course, not be indexed to inflation) will not get tax free withdrawals from Roths. Unfortunately, we have seen that movie before.

[CoachKandSportsguy]

From the presentations I have seen, and the optimizations for tax minimizations, and I have only seen a couple, is to diversify your income sources.

What does diversify income sources mean:

It means to have SS or pension,
and then have a 1/3 - 1/3 - 1/3 split between traditional IRA, Roth IRA and taxable account.

The goal is to cover your lifestyle cost, with minimal income. The fewer assets you have, the lower the lifestyle cost needs to be. As your assets grow, your lifestyle costs can grow. Above a certain asset level, lifestyle costs and taxes don't matter. Not many of us have that luxury, so it's about what's your lifestyle cost, and how to best allocate your current assets.

So that being typed:

Each Couple or Individual is unique as far as as lifestyle costs, SS/Pension income, IRA Assets and taxable assets.
And because each of those are unique, there is no simple rule, its more of an optimization between the categories, and which comes first, the lifestyle or the assets?

The answer is the assets drives the lifestyle assuming that you want to run out of assets exactly at death, which is an unknowable. So due to that uncertainty, and the differences between the categories, you will have to create a personalized model based on the inputs, and then figure out the maximum lifestyle costs for your assets to last to age?

when I have time to finish the model I have created to answer that question, I can summarize the inputs and outputs.

good luck until then or with your own personal financial planner.

.

[goneil2024]

OP offers an interesting question, however from a practical standpoint an informed answer is not knowable unless we have all the needed information, which in my view we don’t.

For some a HELOC might be the way to go, then again leveraging portfolio values could work depending on the portfolio, and for some a HECM could be an option. A qualified fee only fiduciary FA should know the clients risk tolerance, time horizon, risk capacity, investment asset composition, investment experience and be in a position to assess the suitability of any such decision.

Family members in my experience are notions for withholding information when it comes to financial matters or simply not knowing what details are important and not mentioning them. So behavioral/social factors could be involved, therefore the best answer to the question might be “it depends”.

All too often important financial decisions are made without knowing the total financial picture.

[CoachKandSportsguy]

OP offers an interesting question, however from a practical standpoint an informed answer is not knowable unless we have all the needed information, which in my view we don’t.

All too often important financial decisions are made without knowing the total financial picture.

I have all their financial information. We built a 20 year financial projection with all variables including two houses, all taxes, IRMMA, IRA withdrawals, buying selling houses at any time, buying replacement cars, down to the monthly food bill and replacing appliances.

And you will never get their financial information, obviously that would be a breach of privacy on TOTV.

Even then, this financial question is the same as a lease versus buy financial exam question, which only involves the effects of the financing question. Anything else is immaterial. . . and all the other IRMMA points are immaterial, as stated in one of the responses.

[retiredguy123]

The financial advisor's recommendation to borrow money is crazy. Don't borrow money when you have money.

[CoachKandSportsguy]

The financial advisor's recommendation to borrow money is crazy. Don't borrow money when you have money.

the advice only makes sense when you realize that the advisor is paid a percentage of asset under management, and he doesn't want anyone to take money out of their accounts.

A professional colleague who worked at Fidelity, used their advisors, and he need to pay for part of college out of his investments. When he asked his Fido advisor which account and how much he can take out, the advisor told him "to start saving more money by cutting your expenses!"

your a meal ticket to most wealth management advisors, nothing more, nothing less. .

[Teemotay]

The financial advisor's recommendation to borrow money is crazy. Don't borrow money when you have money.

I don’t think that applies in every case.

I thought that we should buy our house with available funds when we built 5 years ago. My advisor counseled against that because our 15 year interest rate is 2.5%. Borrow at 2.5% and invest the difference to gain 6-9% on that money. Let’s just say she didn’t have to work to convince me. Our returns under her management have been very satisfying even considering the management fee.

[retiredguy123]

I don’t think that applies in every case.

I thought that we should buy our house with available funds when we built 5 years ago. My advisor counseled against that because our 15 year interest rate is 2.5%. Borrow at 2.5% and invest the difference to gain 6-9% on that money. Let’s just say she didn’t have to work to convince me. Our returns under her management have been very satisfying even considering the management fee.
I don't agree. I have only had one loan in my entire life, and I paid it off within 2 years. People who avoid debt almost always become wealthier than those who don't.

[Bill14564]

The financial advisor's recommendation to borrow money is crazy. Don't borrow money when you have money.

That may be true if you have that money under your mattress but it isn't as clear if you have to pay to access the money and/or if the money is working for you where it is.

- In this case, there is an $11K fee (taxes) to access the $50K needed.
- By year three the loan has cost $11K in interest which makes it look like the loan will be more expensive going forward.
- However, money in the IRA is working for them.
- Accurately predicting returns requires a crystal ball much better than the one I have. Some will say 5% over time, others will say 10%, and still others will anticipate a downturn and losses.
- If the returns are 8% then leaving the $60K in the IRA will result in $4800 in gains each year. Yes, that is taxable but with a 22% tax the net will be over $3700.

- At 7% and a 15 year payoff, the loan will cost $30K in interest
- At 8% over 15 years the $60K in the IRA will earn $70K in simple interest alone (less 22% in taxes is still $56K)

Depending on what the market decides to do, borrowing money today could result in a net *gain* of over $25K in 15 years.

[CoachKandSportsguy]

That may be true if you have that money under your mattress but it isn't as clear if you have to pay to access the money and/or if the money is working for you where it is.

Depending on what the market decides to do, borrowing money today could result in a net *gain* of over $25K in 15 years.

you are basing the decision on future events repeating, which may or may not occur.
Without basing the events on future events occurring, but today's cost of money only, which would you pick? The financing decision reduces discretionary income on a fixed income, versus maintaining the current cost of lifestyle. This type of reasoning increases the cost of retirement lifestyle unnecessarily.

One can always borrow based upon pledging assets, which is called leveraging up and getting more aggressive about borrowing money. Retirement should be about deleveraging and more conservative to guarantee longevity of assets.

increasing personal risk of mandatory future payments against a personal property improvement doesn't make alot of risk management sense for a retired couple with a fixed income, who are currently enjoying their cost of lifestyle.

[Bill14564]

you are basing the decision on future events repeating, which may or may not occur.
Without basing the events on future events occurring, but today's cost of money only, which would you pick? The financing decision reduces discretionary income on a fixed income, versus maintaining the current cost of lifestyle. This type of reasoning increases the cost of retirement lifestyle unnecessarily.

One can always borrow based upon pledging assets, which is called leveraging up and getting more aggressive about borrowing money. Retirement should be about deleveraging and more conservative to guarantee longevity of assets.

increasing personal risk of mandatory future payments against a personal property improvement doesn't make alot of risk management sense for a retired couple with a fixed income, who are currently enjoying their cost of lifestyle.

If you want safe then pull all the money out of the IRA ASAP so their future retirement is not affected by potential market downturns in the future.

If you can trust the market to have positive returns over the duration of their retirement then trust the market to have positive returns over the duration of the HELOC.

Depending on how difficult or expensive it is to make withdrawals from the IRA, if the market returns are as little as 7.5% per year (/12 for the monthly earning) they will have a net gain leaving the money there and taking monthly withdrawals to pay the HELOC. (beyond the middle of the loan the earning rate can even be less than the loan rate and still have a net gain)

There is a risk, everyone's risk tolerance is different, long-term past performance is not a predictor for short term gains/losses, and all the rest. The math is straight forward, the market is unreliable in the short term, and it's impossible to know what any individual might choose given the information.

[Teemotay]

I don't agree. I have only had one loan in my entire life, and I paid it off within 2 years. People who avoid debt almost always become wealthier than those who don't.

Key words here are, “almost always”. I do avoid debt. My mortgage is my only debt.

[manaboutown]

I don't agree. I have only had one loan in my entire life, and I paid it off within 2 years. People who avoid debt almost always become wealthier than those who don't.

I (used to ) LOVE debt, good debt. Over the course of my younger years I was able to purchase several income generating investment properties with little or at times no down payment. These days all but a trivial amount of it has been paid off. What remains is in the 3% interest range and tax deductible so I choose not to pay it off but to amortize it in accordance with its scheduled payments. I have never carried credit card debt or bought a vehicle on time. That would be bad debt IMO.

[retiredguy123]

Key words here are, “almost always”. I do avoid debt. My mortgage is my only debt.
I'm not saying you are wrong. But I had a mortgage once, and I couldn't sleep at night, so I paid it off in 2 years. I never borrowed money again. It is amazing how much money you can accumulate when you have no debt. Some people are an exception and they can use debt to make money. But most people, who borrow money often, never accumulate much wealth. That is my experience.