"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?