The concept of Equity Harvesting seems to be white hot right now in the insurance and mortgage community. While there are sales books in the marketplace that make it sound like a can’t miss topic, caution needs to be taken so you can determine if using the plan is prudent given your situation and set one up in the “correct” manner.
DEFINING EQUITY HARVESTING (EH)
Equity Harvesting is defined as follows:
EH is removing equity from a personal residence through refinancing (or a home equity loan) where the money borrowed is placed in cash value life insurance.
The tool of choice to help clients build wealth in a tax favorable through Equity Harvesting is cash value life insurance.
Why cash value life insurance? Because if properly structured, cash in a policy can grow tax free (income, capital gains and dividend taxes) and be removed tax free (policy loans). To properly structure the policy, it must be over funded with cash using the minimum allowable death benefit that still allows the client to borrow from the policy tax free.
While fundamentally Equity Harvesting is simple to understand, this material starts out with a common person example so you can understand the mechanics the plan.
Example Number 1:
Mr. Smith (“Joe lunchbox”) is married and has a home with a fair market value (FMV) today of $235,000. He has 2 children and a spouse where their combined household income is $78,000 a year. Assume the Smith’s purchased the home for $185,000 seven years ago and that the current debt on the home is $135,000. Assume the current home loan is 6.5% with mortgage payment of $935 a month.
IMPLEMENTING EQUITY HARVESTING
Let’s assume Mr. Smith will use a home equity line of credit (not a refinance) and will remove $76,500 of equity from the home over a five year period (which creates a 90% debt to value ratio on the property).
Equity Harvesting is removing equity from a home to reposition it into cash value life insurance. Therefore, Mr. Smith will access his new line of credit in the amount of $15,300 every year for five years to fund an over funded/low expense cash value life insurance policy.
It is assumed that the life insurance policy used is an equity indexed life insurance policy that has a 1% guarantee rate of return on the cash value, has its growth pegged to the S&P 500 index and locks in the gains annually. It is also assumed that the policy will return 7.5% annually (which is conservative since the S&P 500 has averaged over 11% for the last 20+ years).
Let’s assume that Mr. Smith will retire when he is 65 years old and will withdraw money tax-free through policy loans from his cash value policy from age 66-90 (25-years).
How much could Mr. Smith borrow tax-free from his life insurance policy starting at age 66?
$23,000 each year for 25 years for a total amount of $575,000.
While $23,000 is a lot of money tax free in retirement for a couple who’s annual taxable income is $78,000 a year; the question becomes: what would Mr. Smith have done if he did not implement an Equity Harvesting plan?
Mr. Smith probably would have done nothing. Therefore, $23,000 a year is a significant improvement to Mr. Smith’s retirement income.
The next question is:what is the cost to Mr. Smith for having an interest-only loan on $76,500 of new debt? If the home equity line of credit is at 7.5%, the costs to Mr. Smith would be $478 a month or $5,736 a year.
Therefore, when trying to compare using Equity Harvesting to doing nothing (which in this example means funding a post-tax brokerage account with the money that would have been allocated to the interest expense), Mr. Smith needs to invest $5,737 every year into the stock market and let it grow. When Mr. Smith reaches age 66, he needs to compare how much money he could remove from that account for 25 years to how much could be removed from this cash value life insurance policy.
When investing money in the stock market there are annual expenses. I will assume a conservative 20% blended tax rate (capital gains/dividend tax which is very conservative) on the growth (the industry standard is 30%) and only a .6% annual mutual fund expense (the average is over 1.2%).
For this example, it is assumed that the money will grow in a brokerage account at a gross rate of 7.5% annually (the same rate as the funds will grow in the life policy).
If Mr. Smith invested $5,737 ever year in the stock market, he could remove $19,038 a year every year after tax from ages 66-90.
Remember how much Mr. Smith could remove from his cash value life insurance after tax? $23,000 every year for from ages 66-90.
How much better did Mr. Smith do by using Equity Harvesting to build wealth vs. doing nothing and simply investing money after-tax in the stock market?
$3,962 a year or $99,050 over the entire withdrawal period.
Therefore, Equity Harvesting would be a viable financial tool to help Mr. Smith build wealth for retirement.
However, the above numbers do not create a fair example as the client who does nothing has no loan to pay off whereas the client who uses Equity Harvesting has a $76,500 loan still to pay off. In our example, Mr. Smith will have a $114,399 death benefit from the Equity Harvesting life insurance policy that will pay income-tax free if he were to die at age 90. That will more than pay off the $76,500 debt on the home.
THE TAX CODE
You’ll notice that the above example does not have Mr. Smith selling his house in order to be able to take profits from the sale and then fund life insurance as a wealth building tool. If he did that, the interest on the loan would be deductible, but in the real world, most people are not going to sell their homes so they can implement an Equity Harvesting plan.
Books like SSOYA make readers believe that the interest on home equity debt is deductible by using very clever examples. In the real world IRC Title 26 Section 264(a) would prevent the deduction for most clients. However, as you can see above, Equity Harvesting when you do not write off the interest and when you use “real world” math, works out as a nice supplemental wealth building tool for Mr. Smith.
Example Number 2:
Let’s see how the Smiths can grow their wealth with Equity Harvesting assuming they had a home where they could harvest $200,000 of equity to reposition into a cash value life insurance policy. Using the same assumptions from Example 1, how much could Mr. Smith borrow tax free from his life insurance policy starting at age 66?
$61,000 each year for 25 years for a total amount of $1,520,000.
Question:What is the cost to the Smiths to create this retirement nest egg?
The new home loan amount will be $400,000. At a 7% interest only rate, that creates an annual mortgage payment of $28,000. However, remember that the debt caused by Equity Harvesting is only $200,000, and, therefore, the costs of Equity Harvesting for this example would be $200,000 worth of debt not $400,000.
What is the cost to borrow $200,000 for the Smiths? $14,000 a year.
Question:If you could have an expense where the costs is $14,000 a year and where the “tax-free” retirement income is $61,000 a year for 25 years, would you incur the expense? Their answer should be all day long.
If the Smiths funded $14,000 a year into a typical brokerage account, the Smiths would be able to remove approximately $46,500 from the brokerage account from ages 66-90 vs. the $61,000 after tax that could be removed from the life insurance policy (for a total of $1,525,000 over the 25-year period).
With a fairly conservative life insurance illustration, the Smiths ended up doing approximately 31% better with Equity Harvesting vs. doing nothing (if we assumed they could NOT write off the interest)
As you can see, Equity Harvesting (whether the interest on the loan is deductible or not) is very powerful. Because it is a powerful way to sell life insurance, agents are pitching it heavily and most have no idea that the Home Equity Debt is not deducible if the borrowed funds are repositioned into cash value life insurance (and books like SSOYA are not helping agents understand this point).
This book is NOT a sales book but instead is an educational book meant to give readers real world math to determine if an Equity Harvesting plan will work and a complete discussion of the tax code. To learn more about The Home Equity ManagementGuidebook, please click here.