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PanFinancial Group News

Wealth Care Strategies: Universal Life insurance loan strategy for high-income clients

Thu Dec 7 11:34:11 2006
News and Press Releases
By: Investment Executive

In addition to insurance coverage and “taxsheltered” investing, high-income clients can get access to investment capital and potential tax savings using a 10-8 universal life plan. The 10-8 UL plan incorporates a loan strategy that effectively reduces the amount of money deposited into the plan through a loan facility, while guaranteeing a rate of return on the deposit and the interest payable on the loan for the life of the contract. It is either offered as a distinct policy by companies such as Toronto-based AIG Life of Canada, or as a component of some UL policies issued by companies such as Transamerica Life Canada of Toronto.

As with most insurance policies, cost, terms, conditions and features vary among different 10-8 plans. Clients can customize choices of death benefit and investment options to satisfy their changing insurance needs. They can add riders — such as critical illness, joint-last/first-to-die, disability waiver of premium, among others— to the insurance component of the policy. They can also choose among cost of insurance options, including yearly renewable term, a combination of YRT and fixed term, or level premiums. Normally, the cost of YRT increases with age.

“The 10-8 is suited for high-income and highly taxed individuals who want to aggressively invest to grow their income,” says Philip Kung, president of Markham, Ont. based RGI Financial Services Inc. “It’s unique structure facilitates guaranteed tax-sheltered investment growth within the policy as well as potential growth and tax-savings on borrowed funds.” The 10-8 strategy can also be used in retirement, estate, succession and other financial planning strategies. With this type of plan, the client makes a maximum annual deposit based on the amount of insurance coverage the insurer is willing to provide. The amount of insurance is based on age, sex, health conditions and on factors such as whether the client smokes.

A portion of the total deposit is used to cover the cost of insurance, administration fees and other costs associated with the plan. The remainder is placed in a special account that is used to build up the cash value of the policy.

Following each deposit the policy holder can borrow 60% to 90% of the cash surrender value of the plan. Additional loans can be made following each deposit.Policy loans up to the adjusted cost base of the policy are made tax free. (Put simply, the ACB is the total premiums paid less the net cost of pure insurance for policies issued after Dec. 2, 1982, or total premiums paid for policies issued before this date. The CSV is the amount equivalent to surrendering the policy during the lifetime of the policy owner, less any outstanding policy loan, interest and other surrender charges.)

The policy holder pays a guaranteed 10% interest rate on the money borrowed. When a loan is taken the insurance company transfers an equivalent amount to a special collateral loan account within the policy, which pays a guaranteed rate of interest of 8% to the policyholder.

Funds in the collateral account cannot be transferred or withdrawn or be used to pay monthly charges. On the policy anniversary, the policy holder pays the 10% interest on the outstanding loan balance and the insurance company credits the accumulating fund with the 8% interest on the outstanding loan balance.

The policy owner does not necessarily have to repay the principal portion of the loan prior to death. The policy owner would typically invest the borrowed funds in a business,property or other investment vehicle with a reasonable expectation of earning an income. Generally the interest paid on the loan is tax deductible.

“When you borrow money tax-free, you are effectively reducing the amount paid into the 10-8,” says Kung. “For example, if you deposited $50,000 and borrowed $20,000, you are effectively reducing your net deposit to $30,000.”

The rationale for using the 10-8 UL is that the policy owner should come out ahead by using the loan facility. The net effect of the deposit and the loan is a loss of 2% (10% less 8%). However, if a policy owner has a marginal tax rate of 50% and the loan interest is tax deductible, then the net benefit of the invested loan will be 3% (5% tax savings less 2% net cost).

However, the client could be further ahead if the borrowed funds are invested and earn a positive return of, say, 5%. In this case, the policy owner would make a return of 8% (3% after tax plus 5% on the invested loan) using the 10-8 loan strategy.

Deposits left in a 10-8 UL — that is, funds that are not borrowed — can be invested in a daily interest account, a guaranteed interest account, indexed equity options and other managed accounts. The minimum return on investment may be defined in the policy based on the performance of a specified benchmark. Some policies may also pay a defined investment bonus on specified anniversary dates.

Susan St. Amand, president of Ottawa-based Sirius Financial Services believes that although complex, the 10-8 UL is a good option if the situation is right. She cautions that clients must understand the risks involved. These include having the ability to pay the interest on the loan, having sufficient income to deduct the interest and being able to make the required deposits.

The deductibility of interest paid on the loan is also subject to interpretation. In principle, interest is deductible for tax purposes as long as the loan is used to earn an income from a business or property.

“Every situation is different,” says St. Amand. Ron Sanderson, director of policyholder taxation and pensions, Canadian Life and Health Insurance Association Inc., adds that the interest can be validly deducted if the loan is used for a legitimate business with a reasonable expectation of profit.

However, he warns, the Canada Revenue Agency and the Department of Finance have not yet taken a formal position on the  deductibility of the interest on 10-8 UL loans. This is largely because of concerns about the interest rate on the loan, which, at 10%, appears high and favours a larger tax deduction.

Given the features of the loan, there is a strong argument that the 10% policy loan interest rate is reasonable under the circumstances. “It is not at all clear that the reason for the rate is to increase the size of the client’s tax deduction,” says Mitchell Singer, assistant vice president, tax and estate planning at Transamerica. Using a comparison of historical rates, he says, “The rate must be put in the context of the fact that Transamerica guarantees a rate for the entire life of the contract.

“One must consider the life of an insurance contract in order to determine the potential term for the loan and the period over which the guarantee will apply,” he adds.

The 10-8 UL is a complex plan which, if used in the right circumstances, can provide substantial benefits. Your clients should get the benefit of professional accounting, legal and/or tax advice, prior to leveraging the benefits. IE

Article originally appeared: July 2005