The Double Play vs. Self-directed IRA

Introduction 

How does investing in real estate using a self-directed IRA compare to leveraging the cash value of a maximum over-funded life insurance policy? Does the tax-advantage of the IRA overcome putting your money to work in two places at one time? The goal of this post is to compare investing in a Self-directed IRA to Investing by leveraging the cash value of a maximum over-funded life insurance policy. As usual, I’ll back everything up with numbers and calculations, and we’ll be keeping all of the inputs as apples to apples as they can be.

What Is An IRA/Self-directed IRA?

An IRA is an individual retirement arrangement. That is the IRS’s name for it. Most people simply refer to IRAs as Individual Retirement Accounts. IRAs got their start in 1974 as part of the Employee Retirement Income Security Act. Congress wanted to pass legislation that allowed for individuals to save in a tax-advantaged manner even if their employer didn’t offer a pension. Wall Street loved IRA’s because it provided a tax incentive for individuals to invest and they were ready to take charge of America’s retirement savings.

When the Wall Street brokers took the message to the streets, they left the impression that you had to work with one of them if you wanted to take advantage of an IRA. But understand that ERISA only stated that funds had to be held by a dedicated Third-Party custodian and that investors could invest in any prudent investment. This means that IRA owners can invest in real estate, gold, tax liens, promissory notes, etc. It took awhile to gain awareness, but eventually Self-directed IRA custodians began to appear. These firms merely held the assets of the IRA. They did not provide any financial or investment advice.

A Traditional IRA allows the account owner to deduct their contribution from their taxable income. The assets inside the account grow tax-free until they are distributed at retirement age. When the funds are distributed, they are taxed at the account owner’s ordinary income tax rates. We are going to be comparing The Double Play to a Traditional IRA.

A Roth IRA does not offer a tax deduction on the contributions, but the funds inside the IRA will grow tax-free and are distributed tax-free. Except for the death benefit and the insurance policy fees and costs, a Roth IRA looks very much like a maximum over-funded life insurance policy. That is, the premium of a life insurance policy is paid with after tax dollars and the resulting cash value grows tax-free and can be accessed tax-free.

Is The Double Play Really Even Comparable To An IRA?

An IRA is an account that offers tax advantages because it is held by a 3d party custodian for the benefit of the account owner. Because the account owner never really has their hands on the assets once they contribute to an IRA, all of the gains, and income are no longer considered for income tax purposes. This means that the account owner does not have to pay any income taxes on income or gains derived from assets in the IRA until they are distributed. But they also do not have penalty-free access to the funds until they reach age 50 1/2. And then, once the account owner has their hands on the money, it is considered ordinary income.

Life Insurance, on the other hand, is life insurance. What sets “The Double Play“ policies apart from other policies is that they are specially designed to have as little death benefit and as much cash value as legally possible. You will find that these contracts barely meet the minimum definition of life insurance. So while life insurance cash value is NOT an investment, it has some very unique properties that make it very attractive for the sophisticated investor. The two main properties of interest to us for The Double Play is the ability to take a policy loan against the policy’s cash value or get a cash value line of credit secured by an assignment of collateral against the policy.

It is always important to point out that policy loans are loans against the policy’s cash value. You are not borrowing from your own cash value and then putting it back. You are literally getting a loan from the insurance company with your cash value serving as collateral for that loan.

When utilizing The Double Play you will find that to the extent you were going to invest with the funds anyway, then putting the funds into a maximum over-funded policy and leveraging the resulting cash value will result in significantly higher combined growth over time than if you simply invested in the alternative with your cash. This means that you are literally putting your money to work in two places at one time.

So, to answer the question, NO, The Double Play is not really comparable to an IRA. There is no limit to the amount of money that the policy owner can pay in premium (presuming they qualify for the amount of death benefit provided). IRAs on the other hand, are limited to only $6,500 for individuals. Worse, if you are a high income earner and have access to a 401(k) at work, your contributions to an IRA may be limited.

Let’s take a look at some of the other differences and the pros and cons of each approach.

Pros & Cons

As stated in the previous paragraph, one of the biggest differences between investing in real estate using the The Double Play and investing in real estate using a Self-directed IRA is the limit on annual contributions.  Because IRA contributions are limited to only $6,500 per year, a comparison is only possible for amounts under $6,500 year.

At the time of writing (June, 2021), the real estate market has been booming for many years now. Real estate investors are struggling to find deals that make a good business case. One of the things that helps make the business case for real estate work is the benefit of depreciation. The IRS allows the investor to write off a percentage of the asset value each year. This is not an actual out-of-pocket expense, so the investor ends the year with that cash still in their bank accounts.

Since no income taxes are filed for an IRA, there is no depreciation. This means that it much harder for the business case to show a reasonable rate of return. Income producing real estate is not a good investment for an IRA. It already has an inherent tax advantage. The self-directed IRA is much better suited to investments that would be taxed at your ordinary income tax rate. This includes things like tax liens, promissory notes, and private lending.

Which Is Better?

In order to compare The Double Play with investing in real estate with a Self-directed IRA I wanted to make an apples-to-apples comparison. To do this, I modified my existing Double-play model by:

• Removing the application of the income tax to the year by year investment income for the “alternative”. This allows for the “alternative” to grow tax-free.
• Adjusted the premium amount. If you put $6,500 into an IRA, you can deduct $6,500 from your income when you file your taxes. Thus, the amount paid in premium in the life insurance policy needed to be reduced to account for the taxes on that $6,500.

• I used a 35% composite income tax rate. This kept the math simple and is a reasonable proxy. All of the inputs in the model are dynamic, meaning if you make a change to the tax rate, it flows through the entire model. With a 35% tax rate, the premium on the life insurance policy was only $4,225 per year.
• I applied the income tax on the distribution side. Retirement income calculations are reduced by the estimated tax on the distributions.

Click on the following link to watch a short video where I explain the model and the results:

Advance to the 18:15 point where the overview of the model results begins.

Summary

While the Self-directed IRA results in more asset accumulation, The Double Play results in more after-tax retirement income. The reason for this is that when you start taking income from a life insurance policy, you are not really taking money out of the policy like you are with an IRA. Retirement income is from policy loans. Understand that since the cash value of an Indexed Universal Life tends to earn about a 1 to 2% premium over the current bond market yield^[1], the cash value balance should significantly outpace the loan balance which is at a lower rate of interest.

So whereas financial advisors typically use the 4%-Rule to determine the safe withdrawal rate from retirement savings, the comparable number for an IUL is more like 8%. And considering the tax-advantage of the IUL, this means that an IUL can generate 2 to 3 times the income of a comparable amount of savings in an IRA.

The bottom line is this: don’t stop your analysis at the values reported on your quarterly statements. These are just numbers on a piece of paper. They do not pay bills.

^[1] As expressed by the Moody’s Corporate Bond Yield.