Leveraging Life Insurance

Your life insurance can be a valuable asset to you while you're alive.

Leveraging your life insurance means taking loans by using the cash value of your policy as collateral. Learn why that's useful, how to implement the strategy, and about important considerations.

Is an Insured Retirement Plan (IRP) a good choice for me?

    1. An IRP is most appropriate if you have significant cash flow over what you need to support your lifestyle and business and are taxed at the highest rates. You also need to have a requirement for insurance (such as to pay off estate taxes or long-term debt obligations).

    2. An IRP is a long-term retirement and estate planning tool. You need to be comfortable with working with your advisor to maintain it for decades.

    3. If you suspect you will need additional retirement planning, or want a cushion, an IRP is an excellent solution.

    4. You must be comfortable with leveraging and carrying a long-term loan.

      • If you aren’t, policy withdrawals are another option

What are the advantages of leveraging my life insurance policy?

    1. Tax-free cash to use as you please (typically to invest or supplement your retirement income). In contrast, withdrawals can be taxed as ordinary income. [CHECK]

    2. There is generally no need to repay the loan until death provided you continue to meet the lender’s loan requirements and the policy performs as well as projected or better.

      1. As long as the projections are conservative most policies will be safe to leverage

    3. You can get income while still having an invaluable way to pay off estate taxes, tax-free via the death benefit

    4. You are under no obligation to leverage your policy even if it was initially structured with that in mind. It can remain untapped as an emergency fund if you find you have enough retirement income.

    5. If your children need money now (e.g., to buy a home or start a business), leveraging your policy can allow you to help them without drying up your own pool of assets

What risks are involved in leveraging?

    1. Default risk: if you can’t repay the loan when the lender requires you to (which may be before death if they deem you to no longer meet their loan requirements), the lender may choose to go after assets other than your policy first

    2. Funding risk: if planned funding is interrupted, the policy may not function well, or may lapse

    3. Tax risk: paying off a corporate loan with personal assets can be tricky in the case of a CIRP

    4. Additional collateral requirement risk: can you provide additional collateral if the policy doesn’t perform as expected after you’ve started taking out loans?

    5. Interest rate risk: if prime rates go back up, the projected loan structure may not work and additional collateral or partial repayment may be required unless the policy investments increase as well

    6. Investment risk: if future investment returns are much lower than projected, the policy may lapse, reduce possible loan income, or trigger additional collateral requirements or partial repayments

    7. Interest vs. returns risk: the gap between your policy return and loan interest rates may widen over time, which can be a risk if the loan rate is the faster-growing force. The loan balance may overtake the cash surrender value much more quickly than anticipated.

      • Can be mitigated by making conservative investment assumptions. The loan rate is usually 1%-3% above the projected return rate.

    8. Business practice risk: the lender may decide not to leverage life insurance in the future, cutting off a stream of income. Setting up a new loan arrangement with a more flexible institution may incur additional fees.

    9. Loan requirement risk: the lender may change their lending requirements (such as the maximum CSV-to-loan ratio) or your financial health may deteriorate to the point where you no longer meet them. Remember, the lender considers many factors in approving and continuing a loan arrangement. Setting up a new loan arrangement with a more flexible institution may incur additional fees and higher loan rates.

    10. Retirement Compensation Arrangement (RCA) risk: if it is deemed that a policy was only acquired corporately to fund your retirement, it may be treated as an RCA which was tax implications.

      • This can generally be circumvented by documenting a need for the base coverage, with the loan arrangement as a secondary benefit

What factors are considered by a lender in deciding if they will leverage my policy?

The same factors as would be considered for a standard loan:

      • Character: your credit history, job profile, family situation

      • Capacity: ability to repay, available income

      • Capital: assets available if your business fails

      • Collateral: what else can be used to secure the loan

      • Conditions: how to market and industry factors impact your business

      • Money: your financial ratios and audited financial statements

      • Management: how your business is owned and operated, including succession plans

      • Markets: industry size, level of competition, barriers to entry, power of suppliers and consumers

      • Material: types of collateral available, business assets/inventory, profitability, turnover

What are the different types of loans available?

    1. Line of Credit (LOC): an arrangement where money can be borrowed and repaid at any time. The lender will set an upper limit on how large the loan can be at a given time (generally 50%-90% of the Cash Surrender Value or CSV).

    2. Term loan: you borrow a set amount that must be fully repaid by a certain date. There may be repayments before the terminal date.

    3. Demand loan: you borrow an amount that does not have a repayment date. The lender can request repayment at any time, even if the loan is in good standing.

      • Lines of credit are usually structured as demand loans.

When would a lender request immediate full repayment of a demand loan or line of credit?

    • If you can’t provide additional collateral or loan repayments when required, you may be forced to surrender the policy and pay off the loan balance.

Is there a minimum loan amount?

    • The minimum loan varies by lender, but generally is $500

What determines the maximum loan?

    • The projected cash value of your policy at life expectancy is used to determine the maximum outstanding loan balance. The (cash value) x (% that can be leveraged) is the maximum loan balance. A policy illustration is often used to show the projected CSV.

      • The annual loan possible is calculated based on a projected long-term interest rate on the loan balance

What % of the CSV can be leveraged?

    • Up to a maximum of 90% on universal and whole life policies, but it could be much less (sometimes as low as 50%, depending on the policy investments) depending on the product and the lending institution.

What do I do if the loan balance exceeds the maximum allowed?

    • The lender may require immediate interest or principal repayments, additional funds to be deposited into the policy, or provide additional collateral. The action they take depends on the terms of the loan.

      • If no additional collateral or repayments can be made, the lender will likely force the surrender of the policy which can have negative tax implications. If the loan repayment consumes the whole cash value, personal assets will need to be liquidated to cover the taxation.

        • The risk of this happening can be mitigated by repaying part of the loan with other assets or repaying a small portion every year. Projecting age 100 as the terminal year also reduces risk because it raises the cap for the loan.

What can be pledged as additional collateral, and how much of it can be leveraged?

    • The amount of the additional collateral that can be leveraged varies. In general:

      • First mortgage on a principal residence or cottage: up to 80%

      • Government or pledged corporate bonds: 95%

      • Equities: 75%

      • Commercial property: 60%

      • Money market holdings: 100%

When is loan interest deductible?

    • Loan interest is only deductible if it is paid annually. If the loan interest is capitalized (added to the balance) a deduction is not possible until the loan is paid off - at that time a deduction can be made on the capitalized interest as long as the underlying loan’s interest would be deductible if interest was paid annually.

      • The loan also has to be used to fund or acquire income-producing business or property for it to be deductible. Loans used to purchase holdings that only generate capital gains do not qualify. As long as the investment generates some income along with capital gains, the interest should be deductible.

        • If a shareholder borrows money to make an interest-free loan (or capital contribution) to a closely-held corporation, the interest on the borrowed funds is generally tax-deductible if the loan the shareholder provided to the corporation affects the corporation’s profitability.

      • Interest is not deductible if the loan is used to purchase investments inside a life insurance policy.

      • Interest is not deductible if the loan is used to purchase a prescribed annuity from a life insurance company.

        • Non-prescribed annuities are an exception. Loans used to purchase these will have tax-deductible interest.

      • If a corporation leverages a life insurance policy to pay out a dividend, the loan interest is deductible.

What is the collateral insurance deduction and how and when can I use it?

    • A collateral insurance deductions permits you to deduct a portion of your life insurance premiums if the insurance was leveraged so that the interest on the loan is deductible. In addition:

      1. The borrower and the policyowner must be the same to use this.

        • This means you cannot be a personal borrower using a corporately-owned policy.

      2. The assignment of the policy must be made to a restricted financial institution (i.e. large public banks or banking branches of large public insurers)

      3. The assignment must be required by the institution.

    • The amount deductible in a given tax year is the lesser of the premiums payable and the Net Cost of Pure Insurance, prorated to the portion of the coverage that is currently leveraged.

      • For example, if the face amount of the policy is $4M and the value of the loan in a given year is $1M then 25% of the premium payable for that year is deductible if the conditions under 15(a) are met, up to the lesser of the premiums payable and NCPI in that year.

Why might I want to collapse my IRP?

    • You may want to collapse your IRP if: your investment returns are much lower than expected, the loan rate becomes much higher than expected, you can no longer properly fund the policy or if you need the cash inside the policy immediately.

How can I collapse my IRP?

    • Repay the loan using personal assets. The liquidation of assets may trigger taxation. If you used the loan to invest in a liquid asset, this is a good source of funds. If you don’t have liquid funds available you will likely need to surrender your policy and use the cash value to repay the loan.

      • The policy can then be left in place (if not already surrendered) or cancelled to redeem the cash value (which may trigger a taxable policy gain).

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