A less taxing way to cover an IRS tax liability

02/16/2024 — Key takeaways:

• Clients facing a significant tax liability may be looking for solutions.
• Borrowing or selling invested assets to cover that liability could risk incurring extra taxes or missing opportunities.
• Having securities-backed lines of credit (SBLOCs) in your product portfolio offers the opportunity to retain assets under management as well as to strengthen client relationships.

When clients with a substantial investment portfolio face a significant tax liability, they may be looking for options for covering that liability. Your client could:

• Take a loan from a bank
• Apply for a home equity line of credit
• Sell assets from their portfolio

The first two options merely transfer liability for liability — your client would have the obligation to pay back the loan with interest. Depending on their financial situation, tapping their portfolio could work against their goals for preserving wealth, and the cost of liquidation would include any tax liability resulting from the sale of assets plus the opportunity cost of missing potential gains in the market.

What if you could offer a better solution?

Consider a securities-backed line of credit (SBLOC). An SBLOC can be a good deal for clients who have plenty of collateral that they won’t need for quite a while or aren’t depending on in the event of a sudden emergency. In other words, a borrower could get the immediate liquidity from a SBLOC that they need without having to liquidate assets in their investment portfolio.

Here’s another consideration for clients age 65 and over: Because the individual would be borrowing rather than liquidating, there’s no concern about generating enough income to be pushed into a higher bracket that could trigger income-related surcharges on their Medicare premiums.

SBLOC interest rates tend to be lower than would be found in a traditional loan, a home equity line of credit or a second mortgage. Meanwhile, investments continue to have the potential for growth throughout the loan period. If the borrower is averaging 6% growth on their investments and the interest rate of the SBLOC is 3%, the math works for their benefit.

The interest on the loan is potentially deductible, especially if the loan is used to generate taxable income through, for example, improvements to a rental property or purchasing equipment for a business. Borrowers should consult a tax advisor first, as not all interest is tax deductible.

Of course, you should consider potential downsides as well

As you discuss SBLOCs with clients, you’ll want to be certain that they understand that the lender will put a hold on the collateral. This means that a significant percentage of a client’s assets could be unavailable to them.

Securities-backed loans are usually offered with a variable interest rate. If rates go up, the amount a borrower ends up owing could be more than they originally anticipated.

The prices of securities in a portfolio are constantly shifting, which means that the collateral backing the line of credit may be volatile. In a down market, the value of the collateral could decline, potentially leading the lender to demand that the loan be paid off or that more money be contributed to the portfolio account. If the individual is unable to do either of these, the lender could sell the collateral without your client’s approval, which could trigger tax consequences and lead to an uncomfortable situation between you and your client.

Final thoughts

In conclusion, having SBLOCs among the products and services you offer affords you another opportunity to retain assets under management as well as to strengthen client relationships by providing broader holistic planning and solutions, meeting more of their needs.

But as with all financial products, it is best that you and your clients who are considering an SBLOC fully understand the benefits and risks that come with these contracts.