An actuary and family enterprise advisor who became an insurance advisor at Taxevity Insurance, a family practice.
A lever lets you do more with less effort.
Leveraging life insurance means taking loans by using the policy’s cash value as collateral. This is one of the advantages you get. Learn why leveraging is tax-effective, how to leverage, and important considerations.
- 1 Why not make a withdrawal from your life insurance instead?
- 2 Why is leveraging life insurance attractive?
- 3 What life insurance products can you leverage?
- 4 What are the two forms of leveraging life insurance?
- 5 Who are the lenders for leveraging life insurance?
- 6 What are the advantages of leveraging your life insurance policy?
- 7 What are the risks of leveraging using life insurance?
- 8 Other questions
- 8.1 What factors do lenders consider before approving your collateral loan?
- 8.2 What are the different types of loans available?
- 8.3 When would a lender request immediate full repayment of a demand loan or line of credit?
- 8.4 Is there a minimum loan amount?
- 8.5 What happens if your loan balance exceeds the maximum allowed?
- 8.6 What can you pledge as additional collateral, and how much of it can you leverage?
- 8.7 When is your loan interest deductible?
- 8.8 What is the collateral insurance deduction, and how and when can you use it?
- 9 Is leveraging life insurance right for you?
Why not make a withdrawal from your life insurance instead?
If you take a withdrawal from the cash value in your permanent life insurance, your death benefit may decrease. All or part of most withdrawals are taxable as ordinary income at your marginal tax rate.
If you want to repay the amount of the withdrawal, you likely cannot restore your coverage to the previous level.
Why is leveraging life insurance attractive?
When you take a loan, your cash value continues to grow inside your life insurance. You are not reducing the amount of the death benefit either (though the loan must be repaid before your beneficiaries receive the remainder of the payout).
What life insurance products can you leverage?
To leverage, your life insurance requires a cash value. That is available with whole life and universal life, two forms of permanent life insurance. Lenders prefer whole life because of the smoother investment returns and inflexible premium structure (which makes projections more accurate). The result is that with whole life insurance you can leverage a larger percentage of the cash value.
Lenders see the strengths of universal life insurance as weaknesses:
- Premium flexibility: you decide when and how much to deposit, which reduces the accuracy of lenders’ projections
- Investment flexibility: you choose from dozens or hundreds of options, which can make returns more volatile and less predictable
What are the two forms of leveraging life insurance?
There are two forms of leveraging with life insurance. There aren’t standardized names. We use:
- Frontend leveraging: borrow now, as with an Immediate Financing Arrangement
- Backend leveraging: borrow decades later, as with an Insured Retirement Plan
Because these situations are so different, they benefit from different product designs. Each has pros and cons. You must select the optimal product design at the outset because you cannot change your mind later.
Frontend leveraging with life insurance
If you want to borrow now, you want the “wealth version” of whole life insurance since you get higher early cash values. The trade-off is lower long-term values.
Backend leveraging with life insurance
To borrow years or decades later, you want the “estate version” of whole life insurance because of the higher long-term cash values. This results in lower early cash values. Here, the people who cancel their coverage in the early years are penalized with hefty cancellation charges. These funds are used to give more to the people who keep their coverage.
Tip: Since permanent life insurance is meant to last for life, our clients tend to select the version that provides the higher death benefit: the estate version. If they want frontend leveraging, they either accept the smaller loan or provide additional collateral to borrow more than the cash value allows on its own.
Who are the lenders for leveraging life insurance?
You can take loans from two lenders:
- Policy loans: from the insurance company
- Collateral loans: from an external lender
Policy loans with life insurance
You usually have a contractual right to take loans against the cash value of your life insurance. This is convenient and private. You aren’t required to repay the loan interest (it gets added to the loan balance) and you aren’t required to repay the policy loan (the balance is deducted from either the death benefit when you pass away or the “surrender value” if you cancel your coverage). The loan interest rate may be attractive compared with a normal unsecured loan. The maximum loan might be:
- 90% of the cash value with whole life
- 50-75% of the cash value with universal life
If you borrow more than the Adjusted Cost Basis, the amount of the excess loan is taxable. Since the ACB drops an eventually becomes zero, policy loans are most attractive in the early years.
Collateral loans with life insurance
Most leveraging uses external loans because of the limitations of policy loans. You can’t simply take your insurance contract to any bank branch and get a loan. Insurance lending is specialized and only available from select banks and credit unions.
With a collateral loan, you assign your insurance contract to the lender. This ensures that the lender is repaid when you pass away or wish to cancel your policy.
With frontend leveraging of whole life insurance, a collateral loan can provide as much as 100% of the cash value or 100% of premiums paid (this is attractive since the sum of premiums paid is larger than the cash value in the early years). Backend leveraging is similar to policy loans; the maximum loan might be 90% of the cash value with whole life and 50-75% of the cash value with universal life.
As with policy loans, you aren’t required to repay the loan interest (it gets added to the loan balance) and you aren’t required to repay the loan during your lifetime (the balance is deducted from either the death benefit when you pass away or the “surrender value” if you cancel your coverage). With frontend leveraging, it is often prudent to collapse the loan early to free your life insurance policy to use as you wish. In some cases, the same policy is used for frontend leveraging initially and backend leveraging many years later, provided the first loan was repaid at some point.
What are the advantages of leveraging your life insurance policy?
Leveraging your life insurance contract has advantages:
- Get tax-free cash to use as you please (typically to invest or supplement your retirement income). In contrast, withdrawals reduce your death benefit and may be taxed as ordinary income at your marginal tax rate.
- You can use leveraging to receive tax-free “income” in the form of periodic (perhaps annual) collateral loans while still having an invaluable way to pay off estate taxes, tax-free via the death benefit.
- 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.
- If your children need money now (e.g., to buy a home or start a business), leveraging your policy lets you help them without depleting your own pool of assets.
- Depending on how you use the loan, there may be tax deductions available (this applies mostly to frontend leveraging with an Immediate Financing Arrangement).
What are the risks of leveraging using life insurance?
All forms of borrowing have risks:
- Default risk: if you can’t repay the loan when the lender requires you to (which may be before death if you no longer meet their loan requirements), the lender may choose to go after assets other than your policy first.
- Funding risk: if planned funding of the premiums is interrupted, the policy may not function well, or may lapse.
- Tax risk: paying off a corporate loan with personal assets can be tricky in the case of a corporately-owned backend leveraging strategy like a Corporate Insured Retirement Plan.
- Additional collateral requirement risk: can you provide additional collateral if the policy doesn’t perform as expected after you start taking loans?
- Interest rate risk: if prime rates increase, the projected loan structure may not work. Additional collateral or partial repayment may be required unless the policy investments increase as well.
- 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.
- 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.
- 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.
- 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.
- 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 do lenders consider before approving your collateral loan?
Lenders consider the same types of factors they would for a non-insurance loan:
- Character: your credit history, job profile, family situation
- Capacity: your ability to repay the loan and the available income
- Capital: assets available if your business fails
- Collateral: what else can be used to secure the loan
- Conditions: how do 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?
- 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.
- Term loan: you borrow a set amount that must be fully repaid by a certain date. There may be repayments before the terminal date.
- Demand loan: you borrow an amount that does not have a repayment date. The lender can request repayment anytime, 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?
Is there a minimum loan amount?
The minimum loan varies by lender. You have more flexibility and lower requirements with a policy loan than a collateral loan from a third-party lender.
What happens if your 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 entire cash value, personal assets will need to be liquidated to cover the taxation.
The risk of this happening can be mitigated by projecting age 100 as the terminal year because it is more conservative (a structure designed to last longer is more likely to do so than one with an earlier projected expiry age).
What can you pledge as additional collateral, and how much of it can you leverage?
If your loan from a third party exceeds the cash value in your policy, the lender will typically require you to assign additional collateral for the amount by which the loan exceeds the cash value.
Lenders typically accept a wide range of assets. The portion of additional collateral that can be leveraged varies and can change. In general:
- Letters of credit: 100%
- GICs: 100%
- 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 your loan interest deductible?
Loan interest is only deductible if it is paid annually. If the loan interest is capitalized (added to the loan 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 you use it?
A collateral insurance deduction 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:
- 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.
- 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)
- 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.
Is leveraging life insurance right for you?
We prepare and explain options to help you decide whether leveraging your life insurance is right for you.