Operation Twist” is the name of Federal Reserve Chairman Ben Bernanke's latest ostensible effort to shore up the financial system and boost the economy.
It remains to be seen if the Chairman's moves help either or both objectives come to fruition. But one result of his actions is that already-low long-term interest rates have fallen even further — for better or worse.
Instead of bemoaning the wisdom or effect of this most recent development, you can help certain clients perform an “Operation Twist” of their own, lowering their taxes now and later, and increasing their safety and flexibility.
The ideal clients for this maneuver are in their 50s or 60s, and considering retiring within the next few years. They have accumulated a substantial amount of home equity, and currently have a high-five- or low-six-figure annual gross income.
More importantly, the majority of their liquid assets are in tax-sheltered retirement accounts (like IRAs and 401(k)s), but the clients aren't currently maximizing their contributions to pre-tax retirement accounts.
Taking the plunge
The first step to this strategy is usually the most difficult for sensible clients to accept: taking out a new, 30-year mortgage, for as much as the lender will allow (usually 80 percent of the home's current appraised value).
Several reasonable objections might spring to their minds (and yours), including an aversion to taking on new debt, questions about the home's valuation in the current environment, and the associated fees and expenses of a new mortgage.
But the main issue will usually be, “What would we do with the proceeds?”
Where the money should go
Rather than imply that your investment prowess can out-earn the cost of the mortgage's interest, you should tell them how they can get an “instant” return on the mortgage money in the form of a lower tax bill.
The trick is to use the proceeds to maximize the clients' contributions to their pre-tax retirement plans. As you no doubt know, in 2011 the limits for 401ks and 403(b)s are $16,500, with another $5,500 for workers over the age of 50.
The clients may also be able to reduce their tax bill even further by setting money aside in a tax-deductible IRA or spousal IRA. The limits are $5,000 per person per year, and $6,000 for those over 50.
The magic number
What's almost as important as the IRS contribution limits is what amount will provide the most bang for the buck, by lowering the clients' taxes right now. Especially if the increased pre-tax contributions bring your clients down to the 15 percent federal tax bracket.
The figure that determines your clients' federal tax bracket can be found on Line 43 of the 1040. For 2011 the ceiling on the 15 percent bracket is at $69,000 for married couples filing jointly, and half that amount for singles.
Any income that exceeds the 15 percent ceiling can be taxed at 25 percent or more at the federal level.
The first step to proving the merits of this idea to your clients is to get a copy of last year's 1040, and check the figure on Line 43.
If that number is over $69,000 (for married couples), and the clients had more room to save in a pre-tax retirement plan, every dollar that could have been set aside but wasn't cost your clients anywhere from 25 to 35 cents, depending on their eventual federal tax bracket.
“But what about the interest?”
Let's say a couple has a debt-free home appraised at $250,000, with little in non-retirement savings, and (since they each work and have a 401k) the ability to put $30,000 more annually into their pre-tax retirement plans.
Their spending levels now are relatively moderate, but they still can't seem to find an extra significant amount of money to save in their pre-tax plan at work.
They heed your advice to take out a new 30-year fixed-rate mortgage at 4 percent interest, for 80 percent of the value of their home ($200,000). The annual interest cost in the first year of the mortgage will be about $8,000.
But if they are in the 25 percent federal income tax bracket now, using some of the mortgage proceeds to save, say, $30,000 more into a 401(k), 403(b), or IRA could save them $7,500 in federal taxes, just about offsetting the cost of the interest (which, by the way, may be tax-deductible).
In theory, they could keep this strategy going for almost seven more years, when the last of their $200,000 mortgage proceeds would be transferred to their pre-tax retirement plans.
At this point they'd still have 23 years of mortgage payments — but they'd also be seven years closer to retirement.
At retirement, the clients still have the outstanding mortgage balance.
But since they can now draw from their retirement plans as they see fit, there is a good chance they can meet their required living expenses with money pulled from their IRAs, and still remain in the 15 percent federal tax bracket.
This ideal existence is made even more likely by the fact that, at most, only 85 percent of their Social Security payments will be taxed as income.
And regardless of the rate at which their income is taxed now and in the future, the new mortgage proceeds can be used to cover other urgent and unplanned expenses, as well as a hedge against rising interest rates and inflation, falling home prices, and tighter lending standards.
All they have to do to remain in their homes for as long as they wish is to make the relatively-small mortgage payment every 30 days — an amount and frequency that can probably be covered easily by a Social Security check.
Who should steer clear
This tactic is not for everyone, including those who tremble at the notion of new debt, fear they would lose or waste the proceeds instead of saving responsibly, or believe that interest rates will never be higher in their lifetimes.
But that last outcome may be one that not even the Chairman can guarantee.
Kevin McKinley CFP is principal/owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book, Make Your Kid A Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. Find out more at www.mckinleymoney.com.