By default we set up every taxable (i.e. non-retirement) account to have margin but we almost never use it. (You don’t want retirement accounts to have debt at the account level because it gives rise to UBTI – unrelated business taxable income – which is taxed at the high trust rates, but you get no basis in the IRA for it. In essence you end up getting taxed twice on the income. Leverage in the underlying investment – debt that a company holds, or a leveraged ETF – is This is why leveraged ETFs are sometimes used (but not y us): leverage in the underlying investment is fine from a tax perspective.)

If you have a diversified portfolio with both stocks and bonds (as almost everyone should) and then you add leverage through margin interest you are essentially long fixed-income and short fixed-income but almost certainly paying on the spread. It is far better to liquidate bonds (for temporary needs) or a portion of the portfolio as a whole (for longer-term needs). Nonetheless we occasionally have clients in margin for the following reasons:

1. The client needs/wants funds right away and it is worth a few days of margin interest expense to them rather than waiting for the trade to settle.

2. The client needs/wants funds and all the positions in the account have large short-term gains. This usually only happens when it has been less than a year since the client came on board or tax loss harvesting was done and the market subsequently moved up nicely. If the gain will be long-term in 10 days (for example) it might make sense to send them the funds, putting the account into margin for the 10 days, and then liquidate the position to repay the margin loan after the taxes are more favorable. For example, assume a 10% unrecognized gain, a 20% differential in long and short term tax rates, and 7% margin interest rate, and a need for $100,000. 20% of the $10,000 gain is $2,000. 7% of $100,000 for 10/365 of a year is $192. Obviously the larger the gain and the shorter the period until it becomes long-term the more this makes sense.

3. Similar to the previous item, if it is December and the client’s tax rate will be lower the following year it might make sense to use margin. For example, suppose the gains are long-term, but they are in the 15% LTCG bracket this year, but will be in the 0% LTCG braket next year. There is a 15% difference in the rate by waiting until the next year to sell.

4. The client anticipates putting the funds back before too long and doesn’t want to disturb their asset allocation (paying transaction fees to sell and then repurchase later) and paying taxes on gains. For example, suppose a client has a bonus coming (with very high probability)  in 60 days, but they find the “perfect” house to buy now and don’t want the opportunity to get away. It might make sense to take funds out of the account (causing it to go into margin) to purchase it and then replace the funds shortly when the bonus arrives.

In most cases, there are even better sources of short-term funds than margin interest – a HELOC (Home Equity Line Of Credit) for example – but sometimes it does make sense to use margin, temporarily.

Financial Professionals Winter 2019

The optimal savings vehicles are client-specific, both in what they may have available to them, and in what would be prudent for their specific situation.  Nonetheless, in general, this is usually the right order (exceptions and other issues at the end) for a typical client who expects to be in a lower tax bracket in retirement than they are now:

1. Tax-deductible, employer-based retirement plans (such as a 401(k) plan) to the extent of any match – a match just can’t be beat!
   • For a married couple, priority of funding must consider:
     • the better match
     • the better investment options (but if the spouse with poor options is changing jobs soon it can be rolled over to an IRA so it doesn’t matter as much)
     • the longer deferral (the younger spouse will have lower RMDs in retirement if desired)

2. HSA savings account – tax-deductible on the contributions and tax-free withdrawals (if used for medical expenses) later (ideally in retirement).

3. Tax-deductible, individually-controlled retirement accounts (such as a traditional IRA) – broad investment options and generally more favorable “exceptions” if early withdrawal became necessary.
   • For a married couple fund the younger spouse’s first.

4. Tax-deductible, employer-based retirement plans (such as a 401(k) plan) from the match (see #1 above) to the limit.
   • For a married couple, priority of funding must consider:
     • the better investment options (but if the spouse with poor options is changing jobs soon it can be rolled over to an IRA so it doesn’t matter as much)
     • the longer deferral (the younger spouse will have lower RMDs in retirement if desired)

5. Tax-free retirement vehicles (such as Roth IRAs).
   • For a married couple fund the younger spouse’s first (this currently doesn’t matter, as there are no RMDs, but the law could change)

6. If education funding is desired see College Funding.

7. If tax-inefficient investments (such as taxable fixed income) will not fit inside the previous options on this list see Asset Location Strategy (the five items at the end).

8. Taxable investments (regular brokerage accounts).

Important caveats and other comments:

1. I have ignored liquidity needs in the list above.  Of course short-term liquidity may take precedence over some of the options listed and funding #5 (since original contributions can be withdrawn without penalty) prior to #2-4 might make sense.  (Though probably not in place of #1.)

2. I have ignored the “investment” opportunity of reducing debt.  There may be behavioral and psychological issues that would impact the order, but from a purely financial perspective, there is low-rate (typically mortgage) debt and high-rate (typically consumer) debt:
   • High-rate debt should generally be paid after #1, but it will depend on the specific situation.  (Perhaps the client can both pay off the debt in a reasonable time frame and fund retirement vehicles.  If they are going to max out the retirement plans every year going forward, they probably want to use them now too, not just after the debt is gone, since there is no “catch-up” when fully funding.)
   • Low-rate debt should probably be paid down at #6 or #7 (in that order) if either is applicable.

3. Investing in human capital (education or skills), particularly for a younger person, might be a better investment than many of the options above.  (Though probably somewhere below #1.)

1. Fixed income is held for risk reduction, not return enhancement. It is the ballast that allows the ship of your portfolio to withstand the financial storms that periodically roil the markets.
2. It is conventional wisdom that “correlations go to one” in times of stress, but this is incorrect. Correlations between risky investments go up, but the correlations between risky assets (stocks) and safer assets (investment-grade bonds and cash) go down in periods of market stress.  Thus, the fixed income portion of a portfolio should include only the safest categories of bonds.
3. A fixed income portfolio should be equally weighted between nominal bonds and inflation-protected bonds to hedge unexpected inflation, unless the investor has exposures elsewhere that should be hedged (e.g. a very large pension with no COLA, or a real-estate portfolio with long-term, fixed-rate financing and short-term leases).
4. If foreign bonds are used in a portfolio they should be currency hedged.
5. Since liquidity in the bond market is higher for large (institutional) transactions than for smaller (retail) transactions, (inexpensive) bond funds, rather than individual bonds, are typically better for retail investors.
6. Due to interest being recognized immediately and as ordinary income, fixed income is ideally held in tax-sheltered accounts. If that is not possible, alternative exposures might be advantageous.  In addition, some alternative exposures might be better than traditional fixed-income investments regardless.  Here is a list of alternative types of fixed income grouped by when/why they should be considered:
   1. Better tax treatment but lower return (so benefits correlate with tax-bracket and interest-rates):
      1. Municipal bonds.
      2. Variable annuities (a plain-vanilla, inexpensive wrapper solely to defer income taxes).
      3. Permanent life insurance.^*
   2. Better tax treatment without any reduction in return (so advantageous if fixed income would otherwise be held in a taxable account):
      1. Non-deducible contributions to IRAs or other retirement plans (defers interest that would otherwise be taxable annually).
   3. Potentially higher returns (tax treatment is not a primary factor):
      1. Debt reduction if the after-tax interest rate on the debt is higher than an equivalent-duration bond with no credit risk.^*
      2. Social Security delayed-claiming (equivalent to purchasing TIPS).^*
      3. Pension annuitization rather than taking the lump sum is equivalent to purchasing fixed income.^*
      4. Human capital investment (additional education and training), particularly for younger individuals.^*

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^*Other factors, in addition to just taxes and rate of return, will affect the prudence of this option.

Financial Professionals Fall 2018