Introduction
Are you using a Policy Loan on Life Insurance policy for investing in Real Estate? Are you using a Policy Loan from the insurance company? If so, you need to read this article! It’s important to understand that you should never use a Policy Loan on Life Insurance when you do The Double Play.
It’s important to point out that the interest expense deduction reduces the taxable income on your investing activities. It is a key factor of The Double Play. So whenever I hear an agent talk about using a Policy Loan to access the Cash Value, it is clear to me that the agent probably isn’t a Real Estate Investor themself. If they were, they should realize that the interest is not tax-deductible.
The goal of this article is to illustrate the significant improvement in The Double Play when using a tax-deductible Cash Value Line of Credit (LOC) instead of a Policy Loan on Life Insurance.
[2024 Update – It’s important to point out that this article was originally written back when Market Interest rates were much lower. Right now, Policy Loan rates from some companies are MUCH lower than what you can get from a bank. I would just remind you that The Double Play is a lifetime strategy for wealth accumulation. Rates will undoubtedly keep changing. The main message of this article will be important to remember]
Overview
It’s important to understand that Policy Loan interest is not tax-deductible. Policy Loans are considered personal loans. There are three key success factors when implementing The Double Play:
- You need to have a properly-designed, maximum over-funded life insurance policy.
- Use a Cash Value Line of Credit (CVLOC) instead of a Policy Loan on Life Insurance.
- Use and Indexed Universal Life instead of a Whole Life
In this article, I’m focusing on the second point: use a CVLOC instead of a Policy Loan on Life Insurance. As we will see, the interest expense reduces the taxable income from your Real Estate investing activities. Remember, if you are giving less money to the IRS, you are keeping more for yourself. Keep reading to see the numbers!
Just a reminder: Check out “How Life Insurance Works” if you need a basic tutorial on Life Insurance.
Cash Value Line of Credit
It’s important to understand that the best way to access the Cash Value for Real Estate investing is a CVLOC. A business loan being used for legitimate business purposes is business expense.of your life insurance policy for investing in real estate is to use a cash value line of credit from a third-party bank. If the loan is used for business purposes, then the interest is tax-deductible.
I want to make it clear that you can access your Cash Value without “Taking it out”. Whether you take a Policy Loan or you use a CVLOC, you are leveraging your Cash Value. Your business business should be the borrower. You give the bank an assignment of collateral on the Policy as security. The beauty of this approach is that the Policy doesn’t need to be in the business. That means it’s more like a personal guarantee. If you default on the loan, then the lender can seize the collateral securing the loan.
Examples
Since the benefit of tax-deductible interest may not be immediately obvious, we’re going to walk through some examples.
Each example will be based on:
- A $100,000 investment that will generate 10% income.
- The Income Tax rate is 40%.
- Both the Policy Loan on Life Insurance and the CVLOC interest rates are at 5%.
- The dividend rate of the Life Insurance policy is 6%. (Note: that is a 6 percent return on the Cash Value portion of the policy.}
The first example will be our baseline. We will calculate results based on investing with our own cash. In the subsequent examples, I’ll show the advantage of using a CVLOC instead of a Policy Loan on Life Insurance. You’ll find that using a Policy Loan is better than using your own cash but not better than using a CVLOC.
Baseline: No Life Insurance
It’s important to note that the problem with using your own money is that you have no tax deductions. That means you are paying income tax on every dollar of investment income. So while our hypothetical investment return is 10%, the Net return is only 6% as shown in the Table.
Policy Loan on Life Insurance – Interest NOT Deductible
It’s important to remember that since we are leveraging the Cash Value. That means our total return includes both the Dividends on the Policy and the Net Investment Return. The $100,000 of Cash Value securing a Policy Loan will be credited with a $6,000 Dividend. Our money is working in 2 places at 1 time. This isn’t the optimal way of doing it, but its still better than investing with our own cash.
It is very apparent that using a Policy Loan on Life Insurance doesn’t work because both the Interest and the Taxes come off the Investment return. Our $10,000 investment return drops to only $6,000 after the taxes are paid. Then, to make it worse, the $5,000 interest reduces the gain to only $1,000.
The combined return between the Life Insurance policy and the Investment is 7%. It’s important to point out that this is only 1% greater than our baseline scenario (6% net).
Now let’s take a look at a situation where we are using a cash value line of credit and the interest is tax-deductible.
Using a CVLOC to Invest in Real Estate
As you will see, using a CVLOC and deducting the interest as a business expense significantly improves the results. Just as in the prior two examples, we will finish up the year with $10,000 of investment income. The difference this time is that we can deduct the interest on the CVLOC.
The loan interest on our $100,000 line of credit is $5,000. This is a business expense and leaves us with $5,000 of taxable income. In our 40% tax bracket, the tax obligation will be $2,000 leaving us with $3,000 of net income. It’s hugely important to point out that this is 3-times the income of the previous example!
And it looks even better when we look at the total Double Play results. When this $3,000 is then added to the $6,000 dividend we have an overall gain of $9,000 or 9-percent.
Analysis
It’s important to highlight the fact that using a CVLOC instead of a regular policy loan resulted in three times the net income. Realize that this is a 50% improvement in our business results. The net return of using your own Cash to invest was only 6% after tax. The Double Play resulted in a combined 9% after-tax return! These results show why it is so important to be able to deduct the interest.
Yeah, but…
I know what you’re thinking. You’re thinking “What about the ‘high’ fees and expenses when you’re first starting out?”. I want you to think about the power of compounding interest. In our examples above, would you rather have $100,000 growing at 6% or $85,000 growing at 9%?
If you understand the power of compounding interest, you know that the 9% return will eventually work out in favor of The Double Play. But if you are more of a visual learner, I’ve created this graph for you:
Look at the substantial difference at the end of 15-years!
The Importance of Policy Design
Are you wondering where I pulled this $85,000 number from? That is how much Cash Value you should have from a single $100,000 premium. Yes, if you can afford it and justify the need for the Death Benefit, you can fund a policy with $100,000 premiums. I have many clients with policies of this size. And larger. This is what the Cash Value to Premium ratio looks like in a Properly-designed, Maximum Over-funded Life Insurance Policy.
It’s important to realize that not only do we have to make up the 15% loss, but we also have to catch up to where we would have been. The Graph clearly shows how the combined growth quickly catches up to where we would have been. Note: This is for illustration purposes only. My goal here is just to show the power of compounding interest. I am not factoring in the cost of insurance. Nonetheless, we can see that the Cash Value of a Properly-designed policy would catch up to the baseline scenario shortly after the 6th policy year.
Multi-year Premiums
It’s important to point out that the prior Graph was looking at the Cash Value of the initial premium in isolation. Remember that in the real world there would be new premium being paid into the policy every year. I think its important that you see that the crossover point occurs relatively quickly.
You should know that the second and subsequent year premiums will have the same expenses as the first year. This is what it looks like when we look at an actual policy funded with Premiums for only 7-years.
Both the “Real Estate Only” and Life Insurance examples were funded with $40,000 each year for 7 years. The “Green” line shows a Properly-designed Policy with approximately 85% Cash Value to premium. It’s important to highlight that The Double Play surpasses the “Real Estate Only” scenario around the 12th year of the Policy (Age 59).
The Blue line on this graph shows an “infinite banking” policy design. Be aware that agencies purposely design infinite banking policies (and similar marketing schemes) with only 65% Cash Value to Premium. They leave these policies under-funded to create the illusion that Policy Owners are “paying themselves interest”. In reality, the company adds any excess over the Policy Loan rate to the Policy as excess Premium. I want you to see how investing in real estate with an improperly designed Life Insurance policy impacts your finances.Use a Maximum Over-funded Policy!
Conclusion
It is important to understand that The Double Play is optimized when we can deduct the interest on Policy Loans. The Double Play is a long-term wealth accumulation strategy. You will make more money over time. Just keep in mind that we don’t want to purposely make it a long(er) term strategy by not using a CVLOC and deducting the interest. It may not be immediately obvious, but when you understand the power of compounding interest and time you’ll realize the benefit of a CVLOC.
Also remember that the problem is only exacerbated when using a poorly-designed policy as the last graph shows.
Optimizing the way you do your business will make a big difference in your wealth accumulation.
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No Rendering of Advice: The financial content in this document is provided for your personal education. It is not intended for trading purposes, and cannot substitute for professional financial advice. Always seek the advice of a competent financial advisor with any questions you may have regarding a financial matter. Information in this document is not appropriate for the purposes of making a decision to carry out a transaction or trade nor does it provide any form of advice (investment, tax, or legal) amounting to investment advice, or make any recommendations regarding particular financial instruments, investments, or products.
The sole purpose of life insurance is for the death benefit protection. Any other benefit is ancillary.
