David H. Kinder, RFC®, ChFC, CLU
Understanding Collateral Uses for Credit and Wealth:
Updated: Feb 7
What is collateral and how can I use it in my life? Learning about the various uses of collateral is not something that is discussed at length in personal finance circles. Normally "all debt is bad debt" when we think of collateral. However, it really depends on what our objective is for using collateral.
Secured Credit Cards and Loans: When one has bad credit or damaged credit, a great way to begin to build good credit is to get a new credit card or other loan and begin making on-time payments on that obligation.
The objective is to begin to build new credit and to reduce the risk for the lender by pledging them some collateral in exchange for having some credit extended.
How do you get credit when you have bad credit? One popular way is to get a secured credit card.
You can start these credit cards with as low as $200 and as high as $5,000 or more (depending on the institution). You give the lender a certain amount that they keep on deposit for you. In exchange, they set up a line of credit for your use pledging the collateral against it. (Pledging means that the lender will get to keep that asset if you default on your obligation; and yes they will send you any remaining balance.)
You can do secured credit cards backed by a savings account and you can do secured loans backed by savings or CDs (certificates of deposit) at banks or credit unions.
Key question: Whose money did they lend you?
The money lent is THEIR money, backed by your collateral.
Auto Loans are also secured loans. These are certainly far more common use of collateral. When you buy a car and you don't have the money to buy the car outright, you often get a loan. The loan is set up where the lender is the owner of the car (or at least 1st listed lienholder) and they have the right to repossess the collateral in the event of default. (Usually by missing two car payments.)
Whose asset (the car) is it? It belongs to the lender. Whose money are you borrowing? The lender's money. The collateral becomes yours as soon as the obligation to the lender is paid in full.
These areas are typical areas when we need more money and we wouldn't want to be in these positions. There are far more advantageous ways to use collateral in wealth building and income tax planning and mitigation.
There are five key areas in the tax code where one can use collateralization and the objective of their use can be FAR more advantageous! Last year, ProPublica published this article on how the wealthiest people avoid income taxes. I'll summarize them below and include two ADDITIONAL areas that are believed to be income tax free but may not be all they may claim to be.
Personal Mortgage(s) including home equity loans & lines of credit: Mortgage proceeds are not reported on your taxes. Could you imagine getting a $1 million mortgage and having to show that you got an additional $1 million of 'income' to declare on your taxes?
Reverse mortgage: A reverse mortgage... is just a mortgage. The difference is, you need to meet the terms in regards to age and amount of equity in the home in order to qualify. Then you don't need to make any payments on the home and any additional accessible equity can be used for anything you wish - income tax exempt! Why? It's just a loan.
Consumer debt: Just as described above, credit cards and car loans, etc. are not considered income for tax purposes. However, these are far more costly in most cases. That being said, they still don't generate any taxable events unless you default on them.
Commercial loan: This is a loan against business or commercial property. Just like with a personal mortgage, it is not considered taxable income to the business who has the mortgage.
Margin loans: This is Warren Buffett's favorite strategy. He pledges his eligible securities to secure a margin loan in order to buy more securities. Again, just like with everything else above, it is a loan backed by the assets he pledges to secure it. (Granted, they must be eligible securities. He can still be subject to a margin call should the pledged securities fall in value.)
Life Insurance Loans (Non-MEC contracts): Life insurance loans are unique compared to the above. There are no additional qualifications (unlike mortgages). There are no credit checks. You fill out a form, sign it, and get your check (or electronic fund transfer) in a matter of days. You can borrow a great deal of your accumulated cash values (perhaps up to 95%). There are many variations of life insurance contracts out there, so I am careful to not make any 'blanket' statements. Generally speaking, a whole life insurance contract is guaranteed by the lender itself (the insurance company) to be worth more every year than other forms of life insurance that may have varying ways to credit interest.) I am not saying that dividends or dividend performance is guaranteed, but just by the fact that they do have guaranteed interest... they will grow each year. Please note that I was specific to point out that loans on life insurance are tax-exempt as long as the contract is a non-MEC or not a "Modified Endowment Contract". How would a loan work against a Modified Endowment Contract or MEC contract? With these contracts (often they are single premium life contracts), any interest or gain within the contract is considered taxable upon withdrawal OR loan. It may not be much (depends on the size of the policy), but it will trigger a tax form should you do so. It's just an important distinction.
Can one or more of these strategies help you to mitigate your tax liabilities in retirement? Absolutely, but they need to be properly evaluated and coordinated. I would not recommend doing this yourself. Work with a financial professional who can help you to coordinate these areas and help you optimize your situation.
You will notice that there is a specific kind of account that you cannot collateralize: IRS Regulated Retirement Accounts.
These include your 401(k), 403(b), IRA, Roth IRA, SEP, SIMPLE-IRA, SAR-SEP, 457, and many more. If you did collateralize them, you will forfeit their tax status in the year of that transaction. I talk more about this in my blog article here: https://www.davidkinderfinancial.com/post/roth-ira-on-steroids
Two other areas I want to talk about:
Roth accounts and Non-Qualified Single Premium Immediate Annuities or NQ SPIAs.
Roth account distributions are tax-free, but they are reported on your taxes on a 1099 form. I wonder why that is?
I have a theory: I believe that eventually Roth distributions will be factored in the calculations on whether to make your Social Security benefits taxable or not. This was what happened with tax-free municipal bonds back in the early 1980's. They included "non-taxable interest" as part of the calculations to determine whether your Social Security will become taxable or not.
As of this date, this isn't part of the tax code. However, based on past-precedent, I believe it will be.
Regarding non-qualified Single Premium Immediate Annuities: This is another great way to get largely tax-exempt cash flow from your assets. However, it does have a small part of every payment that is taxable. It's called an 'exclusion ratio'. I like this strategy when someone is uninsurable. However, just because someone is uninsurable doesn't mean they won't live a long time. It just means they don't meet the underwriter's definition of an acceptable insurable risk. Annuities are not medically underwritten, so this is another strategy that can be used to help you mitigate your retirement cash flow to reduce the impact of income taxes. And if you're wondering how high you'd need the balances in these annuities to be to cause your Social Security to become taxable... that figure is above about $5 million. So they are very efficient for what they do.
If you have questions about how you can optimize your retirement using collateralization, please reach out. We can determine if some, all, or none of these ideas are a fit for your situation.