Five alternatives for bridging a liquidity gap that do not require liquidating assets.
Unforeseen expenses, taxes and time-sensitive investment opportunities are a few reasons why short-term liquidity needs may exceed cash on hand, but selling assets often creates undesirable implications, including transaction costs, taxable events and/or erosion of future performance. Outlined below are several alternatives for bridging a liquidity gap, many of which do not require liquidating assets.
For those with more than 20 percent equity in their home, a home equity line of credit (HELOC) can be an attractive option. HELOCs typically:
- Require little-to-no set-up cost and limited paperwork, but may impose underwriting requirements like property appraisal and mortgage verification.
- Carry a relatively low variable interest rate tied to Prime.
- Allow borrowing up to the lesser of 80 percent of the appraised value less any outstanding mortgage, or $500,000.
- Allow the interest on the first $100,000 of principal to be tax deductible.
Securities-Backed Line of Credit
Rather than sell out of market positions to raise cash, many custodians are willing to issue a line of credit, using non-qualified investments that they hold in custody as collateral. These generally:
- Have little-to-no set-up cost and allow borrowing up to 50 percent of the market value of eligible securities held for more than 30 days.
- Are best suited for short-term needs, as additional cash or a securities sale may be required to fulfill margin calls if the market value of the collateralized securities declines significantly.
- Do not have a pre-set repayment schedule and carry a relatively low variable rate tied to LIBOR (London Interbank Offered Rate).
- Can’t be used to purchase additional market securities, but do not otherwise limit the use of funds.
Cash Value of Permanent Life Insurance
Most whole life policies allow policy owners to borrow against the policy cash value or to use it as collateral to obtain a loan through a bank. Policy loans through the insurance company generally:
- Require little paperwork and reduce the policy’s death benefit by the amount of the loan plus any accrued interest, while the loan is outstanding.
- Do not require repayment; if the loan is not properly managed or repaid, however, the policy owner risks creating an unforeseen taxable event and/or elimination of the death benefit the policy provides.
Bank loans collateralized by cash value often:
- Offer lower rates than the policy issuer, but the bank may impose closing costs and underwriting requirements.
- Repayment is typically required via scheduled periodic payments.
Roth IRA Basis Distribution
Under current tax law, the basis of a Roth IRA may be withdrawn tax-and penalty-free, regardless of the owner’s age or the intended use of funds. Once withdrawn, funds cannot be returned other than through future contributions, so the loss of both tax-deferred growth on those funds and tax-free withdrawals after age 59½ are important considerations.
In-Service 401(k) Loan
Many plan administrators allow employees to borrow against their current 401(k). Terms vary greatly by administrator, but commonly include:
- Loans up to the lesser of $50,000 or (the greater of 50 percent of the vested balance, or $10,000).
- Loss of market exposure based on the loan and interest, payable to the account owner (not the plan administrator).
- Repayment within 60 days of termination to avoid treating the loan as a taxable distribution subject to ordinary income tax and, unless the owner is 59½ years old or older, a 10 percent penalty.
- Repayment required prior to making additional plan contributions.
- The interest portion of each payment is typically made with after-tax dollars, so that small amount ends up being taxed twice: once at contribution and once at distribution.
Although this is not an exhaustive list, each strategy here can help bridge a short-term liquidity gap. Individuals should consult a financial professional to determine which solutions are relevant and most prudent for their specific financial situation.
Saugatuck Financial is a marketing name for Justin Charise, Alfred Schor, and Colin Thomas and is not a broker-dealer, registered investment advisor, federal savings bank, subsidiary or other corporate affiliate of The Northwestern Mutual Life Insurance Company including its subsidiaries, nor is it a legal partnership or entity. Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM), and its subsidiaries. Charise, Schor, and Thomas are Representatives of Northwestern Mutual Wealth Management Company®, NMWMC Milwaukee, WI, a subsidiary of NM and limited purpose federal savings bank, and registered representatives of Northwestern Mutual Investment Services, LLC (securities), a subsidiary of NM, registered investment adviser, broker-dealer and member FINRA and SIPC. All NMWMC products and services are offered only by properly credentialed representatives who operate from agency offices of NMWMC.