"10-8" Leveraging: Creating Tax Deductions

Here's a special offer. For $10 you get an $8 gift certificate. Buy as many as you want.

No takers?

Okay. Give me $5.50 and I'll give you the $8 gift certificate. So you make $2.50 each time. How many do you want now?

This insurance strategy is generically called "10-8" leveraging and used by wealthy Canadians personally or through their private corporations. You get tax deductions while

• investing the way you normally do
• reducing the risks of leveraging through insurance
• increasing the size of your estate

For over 25 months, most of the requests I get have been about "10-8" leveraging. I've done dozens of seminars to attendees from across Canada, trained advisors, met clients, and learned how to make the concept simpler without being simplistic. The appeal is greatest in Alberta, where tax rates are lowest (which reduces the value of the tax deductions). Ontario gets more active each month. Let's explore.

Normal Financial Leveraging
With conventional leveraging, you pay interest and perhaps some of the principal. You face two unknowns:

1. market risk: what your investments earn
2. loan risk: what your loan costs (often fluctuates with the prime rate)

You can't eliminate the market risk but you can eliminate the loan risk with insurance.

"10-8" Leveraging
With insured leveraging, your investment loan costs 10% before tax savings. With a marginal tax rate of 45% (say), you get tax savings of 4.5%, which reduces the cost of the loan to 5.5% after tax savings. Here's the interesting part. Your collateral earns 8% tax-sheltered. So your after-tax cost is 5.5% less 8%, which is -2.5%. A negative cost is a gain. You pick up 2.5% from leveraging.

If you earned 7% before, now you earn 9.5% using the same investment dollars. What if your focus is protection instead of investment? Use the tax savings to reduce the cost of your life insurance below market rates.

The loan becomes a source of income.

What's more, the pretax loan cost of 2% (10% less 8%) is generally guaranteed for life. That's a big advantage over conventional borrowing. When the spread is guaranteed, you want to borrow at as high a loan rate as possible. If you could borrow at 20% , your collateral earns 18% tax-sheltered. Your tax savings double to 9%, giving an after-tax cost of 11%. And a 7% gain from leveraging.

Tax-sheltered Growth
How do you get tax-sheltered growth, using Pink Floyd's insights? By putting cash into universal life insurance policy --- if you like the limited investment choices.

How can you have both the benefits of investment flexibility and tax-sheltered growth? With "10-8" financial leveraging using a specially-constructed universal life insurance agreement.

10 - 8 = 2
There are two types of "10-8" leveraging: policy loans and external collateral loans. The 10% loan interest is paid as follows

• 2% at the beginning of the year to the insurer
• 8% at the end of the policy year to you (your reward for borrowing from yourself)

There's a fundamental difference in the level of tax deductions you can get.

• policy loans: pay 10% to deduct 10%
• external loans: pay 2% to deduct 10%

With external loans, you refinance the 8% at the end of the year by taking another loan. This increases your tax deductions, which is what you and your accountant want. As you'd expect, nearly everyone who qualifies picks this version when dealing with a knowledgeable advisor who has access to both types.

Benefits
Since your loan collateral earns 8% inside a tax-sheltered vehicle, you're getting a nice return. Since you actively invest outside of life insurance, you eliminate both drawbacks we discussed last time.

As you know, there are advantages and drawbacks to financial leveraging. Using insurance reduces the risk by guaranteeing a 2% loan cost before tax savings turn borrowing from yourself into a source of income for you. Using insurance also provides a larger estate than conventional investing. All the while, you're getting tax deductions.

Can you see the appeal of "10-8" leveraging?

Links

• The Pros and Cons of Financial Leveraging
• How Pink Floyd's Insights On Mortality Help You
• The Two Drawbacks of Investing in Life Insurance
• "10-8" Leveraging: Are Tax Audits On The Way? (new)
• "10-8" Leveraging: Turbocharging The Top 5 Insured Strategies (new)

The Two Drawbacks Of Investing In Life Insurance

Tax-sheltered growth in life insurance is great unless you're forced to compromise with

1. limited investment choices
2. relatively high Management Expense Ratios (MERs)
   

These two criticisms have been levied against life insurance. There's a feeling that it's better to Buy Term and Invest the Difference. Insurance investment choices have evolved to better suit the needs of active investors. Here's a history lesson.

Passive Investors
Whole life insurance gave no choice of investments. The insurer made the investment decisions and you got whatever returns resulted. Rather than blindly trusting the insurer, most Canadians wanted more control.

In response, Universal life (UL) insurance was developed and gave let you choose fixed interest investments. Since the highest tax rates are on interest, these investment are ideal for tax-sheltered growth. But this is a small subset of the investment universe. And unappealing to active investors.

Active Investors
Universal life insurance evolved to add indexes as choices for a "buy and hold" portfolio. A handful of mutual funds may also be available. However, you can't invest in vehicles like real estate, your own business or Exchange-Traded Funds (ETFs). Also, the MERs are generally higher inside UL because of Investment Income Tax (IIT), a hidden tax which adds about 0.5% (50 bps) to the Management Expense Ratio.

What good is investing in UL when the investment choices are limited and the MERs are relatively high? Buying term and investing the difference outside seems appealing. There is a solution.

Investing Outside
You can use a cash-rich UL policy as collateral for investment loans. Besides getting tax-sheltered growth inside the policy, you can get three advantages by leveraging:

• unlimited investment choice: you invest the way you normally invest
  
• tax deductible loan interest
• tax savings on a portion of the premium when the lender requires insurance to secure the loan
  

Next time we'll look at "10-8" financial leveraging, a recent innovation which gives you the advantages of normal investing while using life insurance to reduce the risks of leveraging.

Links

• The Pros and Cons of Financial Leveraging
• "10-8" Financial Leveraging
• Canadian Life Insurance Sales in 2007
  
• How Pink Floyd's Insights On Mortality Help You
• The Original And Overlooked Tax-Free Savings Account
• The Overlooked Advantages of Universal Life
• Does Warren Buffett Buy-Term-And-Invest-The-Difference?

How Pink Floyd's Insights On Mortality Help You

you're older,
shorter of breath
and one day
closer to death
--- Pink Floyd, Time

Back To Basics
When you buy insurance on your car or home, you pay premiums which get adjusted annually (usually upwards) based on claims experience. That model doesn't work with life insurance. As closet actuaries Pink Floyd correctly observe, we get closer to death each day. Even if we take care of ourselves, our mortality rates continually increase and increase. If you pay-as-you-go, coverage becomes less and less affordable as payment of the death benefit becomes more likely. Term insurance becomes unavailable.

Tax Incentives
The government uses tax incentives to encourage behavior which reduces burdens on society. For example

• saving for retirement (pension plans, RRSP, Tax-Free Savings Account)
  
• saving for a child's education (RESP)
• saving in general (TFSA)
  

Life insurance clearly qualifies: the death benefit helps families and other survivors. While premiums are not tax-deductible, the death benefit is tax-free.

Big Opportunity
Increasing mortality rates make affordability a big problem. The solution is pre-funding. The government encourages you to invest extra money in your life insurance contract by allowing tax-sheltered growth.

The amount you can invest depends on the cryptic Maximum Tax Actuarial Reserve (MTAR), which varies with the amount of coverage, your age and your health. Since our probability of dying is 100%, you can essentially invest any amount of money --- even millions of dollars.

But why would you?

Because the tax savings on the investment growth are often more than enough to pay for the insurance charges. The government effectively pays for your insurance if

• you're healthy
• you make large deposits in the early years
• you allow time for tax-sheltered compound growth

Needs Change
Tax-sheltered growth is great but what happens if you take money out? As with an RRSP, you pay tax on the investment growth. But you have several advantages over an RRSP

• you can make much larger deposits
• you aren't forced to make any withdrawals
• you can get tax-free access to the savings
  

Suppose you want to supplement your retirement income. Banks like lending when you don't need the money. You can use the savings in your insurance policy as collateral for loans. Since loans are tax-free, you get tax-free income. You don't need to pay the loan interest either. Banks usually let the loan interest accumulate and wait for the tax-free death benefit to repay the loan. What's left goes to your heirs.

Thanks to tax savings, you can benefit from mortality during your lifetime.

Links

• The Original And Overlooked Tax-Free Savings Account
• The Overlooked Advantages of Universal Life
• Does Warren Buffett Buy-Term-And-Invest-The-Difference?

The Pros and Cons of Financial Leveraging

Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.
— Archimedes (220 BC)

Leveraging isn't new. Leveraging isn't complicated.

Leveraging means doing more with less. Doesn't that sound environmentally-friendly?

We leverage time, space and money:

• time: listening to your iPod or radio while commuting (when not eating or drinking or phoning)
  
• space: filling your SUV with passengers and garden supplies on different trips

Yesterday, I saw a BBQ lighter with an LED flashlight. You've seen Swiss army knives. Leveraging is all around us. So why such concern with financial leveraging? When used properly, leverage can be quite advantageous.

What is Financial Leveraging?
Simply put, financial leveraging is borrowing to invest. The most familiar use of leverage is using a mortgage to buy a home. In return for a down payment and ongoing payments, you receive money to buy an asset that would otherwise be too expensive. You hope your home will appreciate in value so that when you sell, you realize a profit over what you bought it for (including interest payments).

This is the principle behind financial leveraging. You gain access to a larger amount of capital and invest to earn a return high enough to make a profit. If your investments perform well, the use of leverage can greatly magnify those returns. This is the appeal.

The Risks

When we pick up one end of the stick, we pick up the other.
— Stephen Covey

Just as gains are magnified, so are losses. As well, increases in loan interest rates may also cut into your profits or add to your losses. It is important to enter into any leveraging strategy with these risks in mind, and take steps where possible to lower the risk level. For example, investing in a well diversified portfolio will help guard against losses and enhance returns. Choosing a fixed-rate loan over a variable rate will also protect you against rising rates (but not falling rates).

There are a number of ways you can benefit from leveraging:

• Investment loans: This is leveraging at its most basic. You use borrowed funds to invest with the hope that returns outpace the interest on the loan. In Canada, you can deduct the interest paid on loans for certain investments, which makes this strategy more appealing, and reduces the effect of interest rates eating into your returns
• RRSP loans: When you borrow to invest in your RRSP, you get two advantages. First, you get the tax deduction for the larger RRSP contribution. Second, the growth of your investment is tax-sheltered within the RRSP which will enhance your returns.
• Universal Life Insurance: The tax-advantaged status of Universal Life makes it an excellent vehicle for many leveraging strategies. The cash value in the policy provides the collateral. You can borrow to invest. You can also get tax-free retirement income (see the Insured Retirement Strategy, the #2 strategy).
  

Is Leveraging for You?

Leveraging strategies range from the basic to the very sophisticated and involve varying degrees of risk. Whether or not you could benefit depends on your financial situation, goals and comfort level with taking on risk. It's definitely not for everybody but nothing is.

Links

• The Problem of "Trapped" Retained Earnings
• Tax Planning: The Top Five Insured Strategies
• "10-8" Leveraging: Creating Tax Deductions