Do Wealthy People Take Out Loans to Lower Taxes

[Rianne]

Our neighbor, a young financial advisor, told my DH the rich take out loans to avoid paying taxes. They take out loans against stock index funds. Then pay back the loans via selling the stock. Because it's a loan, you don't have to pay taxes it. Has anyone heard of this strategy? You pay interest on the loan which is less than the tax you'd pay selling the stock. Maybe this strategy is for the ultra rich who can weather a market downturn. Our neighbor, bless his heart, is always coming up with these unusual financial gimmicks. We won't give him a dime to play with, but find his financial ideas entertaining.

 

[RetiredHappy]

I am not sure what is being proposed. There is no tax deduction on margin loan interests. You cannot offset margin loan interest payments against any gains that you make in the stock market. If the FA is talking about trying to make more money by taking on margins, power to him. My ex-husband got our accounts into margin loans in year 2000 period and I lost $500K in my account due to his great idea. Fortunately I was making alot of money at work and while it was very painful, I recovered. I would never ever touch margin loans again.

 

[PhrugalPhan]

I'm not expert on this but I believe the idea is that instead of paying taxes on highly gained stocks, the rich can take out loans at very good rates based on their stock holdings at excellent interest rates, way less than paying taxes. Rinse and repeat until they die, and the stocks are inherited at stepped up basis. No taxes incurred except for inheritance taxes. I don't know if this is a better way than selling as needed, but I doubt I'll need to worry about this.

 

[Closet_Gamer]

I believe ultra high net worth individuals with high concentration in stocks of companies they have built/invested in may find borrowing against assets rather than selling them advantageous for a few reasons:

1 - they maintain voting control of the shares and hence control of the company

2 - they avoid paying 20% cap gains (+ any state tax gains). They also avoid taking salary from their companies at what may be 50%+ effective rates. Interest payments eat into this over time.

3 - they keep the shares until stepped up cost basis occurs when they die. Their heirs can then sell the stock without cap gains taxes and pay off the loan

4 - they maintain upside opportunity in companies they expect to appreciate over decades.

This may make sense for individuals with sophisticated tax and asset profiles, but I doubt it makes sense for average people.

My $0.02.

 

[jazz4cash]

I thought this strategy was pretty common. The level of wealth comes into play since you will pay a higher tax rate but the interest is the same. Folks with highly appreciated stock are good candidates but anyone could do this. I could even take a share secured loan from the credit union to smooth out income so I don't jump brackets or IRMAA tier levels. They charge 2% above what they pay.

 

[ERD50]

... This may make sense for individuals with sophisticated tax and asset profiles, but I doubt it makes sense for average people. ...

It doesn't need to be so sophisticated or for the ultra-wealthy. My example:

When we bought our current home in 2021, I wanted to make a cash offer since the market was so hot, homes were getting multiple offers, cash would give us an advantage. If I sold my appreciated stock, I would have paid cap gains tax on it, so I took out a loan against my stock holdings. Since mortgage rates were so low, I later took out a mortgage, and paid off the loan against my stocks (the stock loan was not a fixed rate, and has gone way up since then).

I'll soon have a pension, SS, and RMDs for cash flow, so it's very likely that those stocks will pass to my heirs stepped-up.

 

[Closet_Gamer]

Good examples.

I think the ultra-wealthy have been doing this for living expenses.

 

[MichaelB]

Our neighbor, a young financial advisor, told my DH the rich take out loans to avoid paying taxes. They take out loans against stock index funds. Then pay back the loans via selling the stock. Because it's a loan, you don't have to pay taxes it. Has anyone heard of this strategy? You pay interest on the loan which is less than the tax you'd pay selling the stock. Maybe this strategy is for the ultra rich who can weather a market downturn. Our neighbor, bless his heart, is always coming up with these unusual financial gimmicks. We won't give him a dime to play with, but find his financial ideas entertaining.

This doesn’t sound right. When someone sells stock in a taxable account they pay tax on the gain and how they use the proceeds doesn’t matter. Interest on a loan for personal use is not deductible.

High worth individuals have always been able to borrow long term, using their stock holdings as collateral. When long term rates were 1%-2% it might have made sense to borrow against equities instead of selling. With long term rates now at 6%-7% the math is different and not at all compelling.

 

[Winemaker]

But 6-7% interest is way better than 12, 22, 24,32 or 35% income tax.

 

[MichaelB]

But 6-7% interest is way better than 12, 22, 24,32 or 35% income tax.

6% annually for 20 years is a lot more than 20% once.

 

[ERD50]

6% annually for 20 years is a lot more than 20% once.

Right. But it might still be attractive to them if they expect (rightly or wrongly) their investments to beat 6% annually.

 

[MichaelB]

Right. But it might still be attractive to them if they expect (rightly or wrongly) their investments to beat 6% annually.

That’s a possibility. A stock with a dividend rate greater than the interest rate is also a candidate, especially if the objective is to never sell.

We have no way of knowing just how common this may be, but I’ll bet it was much more popular when long term rates were very low.

 

[Koolau]

We have no way of knowing just how common this may be, but I’ll bet it was much more popular when long term rates were very low.

I'll bet you're right. MANY strategies have likely changed since interest rates have risen dramatically. This is the first time in years I've owned a CD, for instance.

 

[ncbill]

my pledged asset line costs ~8%...hardly "ultra-low" interest.

and rates for the above are usually lower than margin rates of interest.

better than paying 23.8% federal plus whatever the state charges...but only for a few years.

 

[Exchme]

ERN discussed this at:

Using Leverage in Retirement – SWR Series Part 49 - Early Retirement Now

November 16, 2021 – My Safe Withdrawal Series has grown to almost 50 parts. After nearly 5 years of researching this topic and writing and speaking about it, a comprehensive solution to Sequence Risk is still elusive. So today I like to write about another potential “fix” of Sequence Risk...

earlyretirementnow.com

It referenced a (paywalled) July 2021 article at the WSJ called Buy, Borrow, Die

https://www.wsj.com/articles/buy-borrow-die-how-rich-americans-live-off-their-paper-wealth-11625909583

For rich folks with illiquid or very highly appreciated assets, it might make sense as long as the lifetime leverage they build up doesn't become too large and risky. As folks mentioned, this idea made a lot more sense at 1-2% interest rates than it does now. Folks that took out a bunch of loans at low interest rates may be finding their loan costs snowballing on them now.

OP's instincts are right that this is not something us "regular" folks should be doing.

 

[RunningBum]

Our neighbor, a young financial advisor, told my DH the rich take out loans to avoid paying taxes. They take out loans against stock index funds. Then pay back the loans via selling the stock. Because it's a loan, you don't have to pay taxes it. Has anyone heard of this strategy? You pay interest on the loan which is less than the tax you'd pay selling the stock. Maybe this strategy is for the ultra rich who can weather a market downturn. Our neighbor, bless his heart, is always coming up with these unusual financial gimmicks. We won't give him a dime to play with, but find his financial ideas entertaining.

This is why financial advisors should not be giving tax advice. If you sell stock in a taxable account for any reason, it is a taxable event and you'll owe taxes if there is a gain.

The only reason I'd use a margin account is as a temporary bridge loan if I was buying a new house and would pay for it with the proceeds from my existing house sale.

 

[SecondCor521]

The applicability of this idea is limited.

First, you have to have a very low withdrawal rate. If not, then the compounding of borrowing your living expenses for years can result in an unacceptably high level of leverage and risk. Ballpark I would guess it would have to be 1% or less. (It might work with a higher percentage if your old and know you have a limited lifespan.)

Second, the arbitrage needs to be worth it. If your borrowing $X at Y% and are making Z%, then $X * (Z - Y) has to be worth the hassle of dealing with a banker and loan applications and repayments and so forth. For a wealthy person, maybe $X * (Z - Y) needs to be $100K.

Let's be generous and assume 10% return and 5% interest. That means $100K = 5% of $X, which means the person would need to be borrowing $2M a year.

At a 1% WR, $2M a year means a net worth of $200M+.

And what person with a $200M+ net worth is going to want to bother with this idea for a "measly" $100K a year?

 

[GravitySucks]

You don’t even have to be all that rich.

It was cheaper for me in 2013 to get a car loan than the tax bump by paying cash. ( Not so much in 2024. )

A HELOC over the past few years was used to help DD buy a house without pushing me over IRMAA levels.

 

[SecondCor521]

^ I guess it might be good to distinguish between this idea being used as a key wealth building idea vs. a way to save a few bucks on taxes.

Several people on this board have mentioned executing the latter idea - postponing realization of income on five figures over a year or three. This approach makes sense to me although I've never done it personally (yet).

The former idea - borrowing all of one's living expenses for years on end - is somewhat different I think because it can be an order of magnitude or more larger.

 

[bada bing]

The things that make this work as a common strategy are:

Stepped up basis. This is the main driver of the strategy. It is mostly about intergenerational wealth planning

Low interest available for margin against large holdings of equities. Margin interest rates just above the prevailing risk free rate are available If you have 8-9 figures in equity. If nothing else, you can maintain "box spreads" for money at just above risk free rates.

The arbitrage between investment returns and interest costs. Leverage on equities, as long as it stays within bounds, has been a winning long term strategy. As long as your long term equity performance exceeds the interest on the leverage, you're better off borrowing for consumption rather than liquidating and realizing LTCG..

 

[Koolau]

The things that make this work as a common strategy are:

Stepped up basis. This is the main driver of the strategy. It is mostly about intergenerational wealth planning

Low interest available for margin against large holdings of equities. Margin interest rates just above the prevailing risk free rate are available If you have 8-9 figures in equity. If nothing else, you can maintain "box spreads" for money at just above risk free rates.

The arbitrage between investment returns and interest costs. Leverage on equities, as long as it stays within bounds, has been a winning long term strategy. As long as your long term equity performance exceeds the interest on the leverage, you're better off borrowing for consumption rather than liquidating and realizing LTCG..

I'm guessing people with 8-9 figures in equities aren't trying to avoid IRMAA or NIIT with this strategy. YMMV.

 

[sparky08]

ERN discussed this at:

Using Leverage in Retirement – SWR Series Part 49 - Early Retirement Now

November 16, 2021 – My Safe Withdrawal Series has grown to almost 50 parts. After nearly 5 years of researching this topic and writing and speaking about it, a comprehensive solution to Sequence Risk is still elusive. So today I like to write about another potential “fix” of Sequence Risk...

earlyretirementnow.com

It referenced a (paywalled) July 2021 article at the WSJ called Buy, Borrow, Die

https://www.wsj.com/articles/buy-borrow-die-how-rich-americans-live-off-their-paper-wealth-11625909583

This. Pay yourself in company equity or real estate, go to your broker and get a loan, using those things as collateral.

If you can't read the article, this guy did a good job of explaining it in a short video. It's how I first learned about the concept.

Buy Borrow Die

 

[Franklin]

But 6-7% interest is way better than 12, 22, 24,32 or 35% income tax.

Just purchased a new home for $1.4M in cash. I need about $300K cash to fix it up. Planning to sell my existing house for a similar amount (so essentially just needed a bridge loan for fix up) I was about to sell some stocks then realized I was in the 37% tax bracket. Contacted a loan broker to get the $300K in a loan or HELOC (in process). Rate is 5.6% and u can prepay when you don't need it. My math said this was much better than paying tax. I would not do a margin loan because it was 9%.

 

[Enuff2Eat]

But 6-7% interest is way better than 12, 22, 24,32 or 35% income tax.

can someone do a mathematic chart comparasion.. between 7% in a long term vs. 20% income tax once?

 

[ERD50]

can someone do a mathematic chart comparasion.. between 7% in a long term vs. 20% income tax once?

3 x 7 = 21. And 21 is greater than 20. So 3 years of 7% is about 'breakeven'. I don't think the math is much more complicated than that.

But there are some complications - the 20% tax is on the gains only, so it would depend on how appreciated the asset was. If the investment was doubled from purchase, the tax would then be 10% of what they sold, etc.

And, if they can make 7% on the invested money, it's a wash. So it all depends.