Avoid Leverage in a Retirement Account Meltdown Strategy

So you did all the right things. You lived within your means and you diligently saved and invested over the years. Now you have accumulated a nice nest egg in taxable and tax deferred accounts. Wonderful! Did you, however, stop to think about the tax implications when you start to withdraw money from your tax deferred accounts?

I have thought extensively about this very matter. While I am grateful that I was able to benefit from tax advantaged accounts over the course of my career, I would like to continue to take advantage of tax minimization strategies when I start withdrawing funds from tax deferred accounts. This brings me to the subject of today’s post.

I have investigated the strategy in which you would marry withdrawals from tax deferred accounts with the use of leverage. In my opinion there are too many pitfalls/risks that could potentially derail any benefits, and therefore, I would avoid this strategy.

How It Works – In Theory

Using the leverage strategy, you would take on an investment loan to buy dividend-paying stocks which would provide income during retirement; dividend-paying stocks have the advantage of being very tax efficient.

The interest payments on the investment loan are generally tax deductible. I say generally because your investments must generate dividend or interest income or have a reasonable expectation of generating such income. If your investments only have a probability of generating capital gains, such as shares that do not pay dividends, the investment loan interest is not deductible.

Since withdrawals from tax deferred accounts are taxed at the same level as ordinary income and in the year you make the withdrawal, you would take on an investment loan so the tax deduction could offset the tax resulting from the tax deferred account withdrawals.

Let’s Use an Example

I will use the following parameters in our example.

• withdraw $15,000 from the tax deferred account which is subject to withholding tax at the time of withdrawal;
• the interest rate on an investment loan is variable and at the time of funding is 4% but is subject to change;
• loan proceeds would be invested in blue chip companies bearing an aggregated current dividend yield of 3.25%.

In my case, I would not receive the full $15,000 when I withdraw funds from my tax deferred account as I would incur a withholding tax on my tax deferred account withdrawals. The following chart reflects what percentage is withheld.

On a $15,000 withdrawal I would incur $2,500 in withholding tax thus leaving me with $12,500.

$5,000 x 90% = $4,500

$10,000 x 80% = $8,000

These proceeds would be able to service the interest on a $312,500 investment loan ($12,500/.04). I certainly do not advocate borrowing this amount....especially in retirement!

Instead of borrowing $312,500, what if we lower the amount to $100,000. In this case, the annual interest obligation would be $4,000/year or $333.33/month (4% interest rate).

Invest the $100,000 in solid blue chip companies with an average yield of 3.25% and you are only generating $3,250/year in dividends.

Risks to Consider

My example results in an annual cash flow shortfall of $750 albeit this is before taking into consideration any tax related benefits.

Now, imagine if:

• the variable interest rate on the loan were to increase;
• some of your investments did not pan out as planned (eg. a dividend cut);
• your investments were made just prior to another major market correction and a portion of your investment evaporated;
• the distribution of the dividend payments is uneven. It is possible the monthly investment loan interest payments may need to be serviced from sources other than the dividend income.

As if that isn’t bad enough, a conventional lender will typically not lend dollar for dollar against securities pledged as collateral. You could very well be faced with having to pledge security above and beyond the value of the shares. Alternatively, you may have a credit facility secured solely on the basis of your name which can be used for sundry purposes. Just be aware, however, that a lender can subsequently change the terms and conditions of your credit facility.

If you want to avoid the risk of a potential increase in your interest rate, you could arrange for a loan at a fixed rate. Loans of this nature are termed out over a period of time and payments include principal and interest. In addition, the interest can also be higher than that of a variable rate loan. Your payments will also include a component which will be applied toward the principal. As a result, your monthly payments would most likely be much higher than in the variable interest rate scenario thus leaving you with a monthly shortfall....possibly every month of the year.

To make matters worse, if you are a Canadian resident and receive dividend income in taxable accounts from US listed companies, you must contend with a 15% withholding tax. If the company pays $1/quarter dividend, for example, your account will only be credited $0.85/quarter dividend.

My Recommendation

I recommend a straight meltdown of a tax deferred account where you simply make early withdrawals from your tax deferred account and allocate the proceeds, net of the withholding tax, to a taxable account. In this case, funds will continue to grow but you will incur taxes on a yearly basis for interest, dividends, and distributed capital gains.

I recognize this strategy will be limited to individuals who do not require funds from their tax deferred accounts to cover living expenses. I am of the opinion, however, that the risks associated with the pairing of an investment loan with tax deferred account withdrawals are too great for most investors and should be avoided.

I wish you much success and would sincerely like to hear from you.