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A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
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Hello there. This is David McKnight. Grateful that you're with us today. You can find out more about me at davidmcknight.com. Of course, you can learn about my books, The Power of Zero and Look Before You LIRP, as well as my upcoming book, The Volatility Buffer are all there as well. You’ll be getting more information about the launch of my book, The Volatility Buffer, very, very excited for you guys to learn about this concept. If you haven't already nestled within a story that has a plot, it has characters, it has a cool M. Night Shyamalan twist ending at the end and I think you're really going to like it.
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Today, we're going to talk about how to take money out of your life insurance retirement plan. How is it that we can take money out of a life insurance retirement plan tax-free. Is there some section of the IRS tax codes? Are there some methodologies or some mechanics behind how we can take money out of a life insurance retirement plan and have it feel like it’s a distribution from a Roth IRA? It's not a Roth IRA, sometimes people will refer to this as super Roth’s, that's technically inaccurate, these are not Roth IRAs. However, the net effect is that in either scenario, you're not paying tax if done properly. I talk to a great extent about how you can utilize the life insurance retirement plan for tax-free distributions, I do that extensively in The Power of Zero, I do it even more extensively in Look Before You LIRP, in fact, I've got a whole chapter on tax-free and cost-free distributions. Every life insurance policy out there allows you to take out tax-free distributions, not all of them allow you to take out tax-free and cost-free distributions. As we’ll learn by the end of today, the costs associated with some of these distributions even though they are tax-free can really, really put you in a bind and so we're going to talk about why that is today.
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First of all, we know that with the traditional life insurance policy, you can always take out whatever you’ve put in. We call this your principle or your basis. If you've contributed $50,000 to your life insurance policy, you can always take $50,000 back out without paying any taxes on it. Why? Because you contributed after-tax dollars to your life insurance policy, to begin with, that's just simply a return of those after-tax dollars. Anyone can take tax-free distributions up to your basis so that's not always a problem. The trick becomes once you start taking out above and beyond your basis or above or beyond your principle, how do you do that such that it does not show up on the IRS’s radar and we do that by way of a loan.
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We're going to talk about two types of loans today. The first type of loan we’re going to talk about is a standard or preferred loan. Now when I say standard, this is typically for the first 6 to 10 years of the policy. You don't take the money out under such favorable circumstances. But that's okay because in the first 6 to 10 years of your policy really, number one you probably want to exhaust all of your other sources of emergency funds before tapping into this. I usually like to make this one of the last things that we tap into in the event of an emergency. But if you did need to tap into it, you really would be withdrawing your basis so you wouldn't have to ultimately resort to what we call the standard loan which would actually charge you a rate of interest and we’ll get into why that is here in a second. What we really want to talk about is the preferred loan, what is a preferred loan? It typically starts 6 to 10 years into the policy.
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Let's talk about how loan works. What happens when you take a tax-free distribution from your LIRP? You are not taking a loan from your own policy, you are not taking a distribution from your own policy once you get above and beyond your basis, what you're actually doing is you're saying, “Hello, life insurance company. I want to take a tax-free loan,” so what they'll do is they will actually loan you money out of their own coffers. Let's just use the number $100,000. They’ll loan you $100,000 from their own coffers, they will charge you a real rate of interest. Let’s say that rate of interest, for today's example’s sake, is 3%, then in the very same breath, they will take $100,000 out of your growth account in your LIRP and they will assign that to, what I like to call, a loan collateral account. That loan collateral account is also assigned a rate of interest, they will credit you a rate of interest.
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Here's how it works, at the end of one year, you have this outstanding loan with a life insurance company, they’ve charged you 3%, just for example’s sake, which means on that $100,000 loan, you now owe them $103,000. However, if your loan collateral account in your life insurance policy is being credited at exactly the same rate, we’ll call it 3%, then at the end of that year, your loan collateral account is exactly the same as the loan account that you have with the life insurance company. All you know is that you ask for $100,000, you got $100,000 in the mail, your growth account went down by $100,000 and you didn't have to report any of it as income.
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Now let's say, just to take a really wild example, that your loan with the insurance company grows to be $1 million by the time you die, should that give us pause? Should that give us cause for concern? Well, it depends. If they have guaranteed that the rate of interest that they're charging you on that loan always remains at 3% and they’ve guaranteed that the rate that they are crediting you and your loan collateral account is always 3%, then we don't really care how high the loan gets. It could be $1 billion because if it's $1 billion, we know that your loan collateral account is mirroring it dollar for dollar because the rate at which they’re crediting you and the rate at which they’re charging you is exactly the same and guaranteed to never change. At death, the loan collateral account pays-off the loan, all you know is that you experience tax-free growth, you took tax-free distributions your whole life as long as there was $1 left in your life insurance policy when you died, then everything reconciled at the end and you experience tax-free distributions.
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Now, there are potential bugaboos here. There are some companies who will say, “We will guarantee to credit you 3% that will never change,” so now there’s our guarantee into credit, your 3%, and your loan collateral account, they guarantee that number will never change. They may even say, “We’ll start you off at a 3% loan charge and so long as that 3% charge doesn't go up, you’re in pretty good shape.” It’s always going to be what we call a “zero cost loan,” “a net-zero loan,” “a wash loan,” whatever you want to call it. However, there are some companies that reserve the right to change that 3% to a 4%, 5%, 6%, 8%, in which case, their fox is in your chicken coop and I guarantee that if you give a life insurance company enough time to make up their mind what they want to charge you on some of these things, they will probably take advantage of it which is why it’s very, very important that you take a look at the loan provisions. I think the loan provisions are probably the most important provision in the entire life insurance contract. I’ve talked to guys who have been in the industry for 30 years, they’re top producers and I say, “Tell me about your loan provision,” they can’t tell me the first thing about their loan provision which is interesting because the loan provision can make or break your policy. When it comes to these provisions, the devil is in the details.
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Let me just give you an example, if you were to go to my book, my second book, Look Before You LIRP—I highly, highly recommend that you read that and get it on Amazon—I talk about the implications of just having a 1% loan, actually we started up with the 2% loan, to give you an example here, let's say you're 65, you had a cash value of $1 million and you want to take an annual loan of $75,000 and your growth account is growing on average of 7 ½% per year, if you have a 2% spread loan, so, for example, let's say they're charging you 5% but they're crediting you 3%, you can take that $75,000 loan every year for 19 years. Then you run out of money at the age of 83 and if you run out of money at age of 83 and you are not dead yet, then all of those tax-free distributions can become taxable to you.
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If you have a 1% spread loan, then that $75,000 distribution lasts 4 years longer, so instead of taking out only $1.4 million to $5 million, you’re taking out $1.7 million to $5 million. However, if you have a 0% spread loan, that $75,000 distribution lasts from age 65 all the way to age 94, you take out $2.25 million. It doesn't seem like the difference in these, what they're crediting and what you’re charging, these spread loans are very big numbers, but over the course of your life at 2% spread loan, and this scenario costs you $825,000, a 1% spread low costs you $525,000, and the 0% spread loan gave you the full $2.25 million. Why do these spread loans, be they one, two, or four, sort of crater your distributions? Why do they impact your distributions over time? The reason they impacted is because at the end of one year, let’s say you have $103,000 in your loan collateral account, the loan account has $105,000, that $2,000 net interest that you owe will actually come out of your cash value at the end of the year. The next year when you take another $100,000 loan, you haven't paid back the loan for the first year, but now you owe that loan again the second year, and then the third year, and the fourth year so you have this geometrical growth of the loan interest that you owe to the insurance company and it starts to take a toll and it can bankrupt your policy in this example from Look Before You LIRP, let's say 11 years before it otherwise would. That's why I say whether when it comes to these loan provisions, the devil is in the details.
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That's really the premise of my second book Look Before You LIRP. You don't buy a life insurance retirement plan simply because the guy across the table tells you that it's a good deal, that's like getting married after the first date. The premise of Look Before You LIRP is you don't get married within the first day. You probably have a laundry list of things you're looking for in the ideal spouse. You should have a laundry list of things you're looking for in the ideal life insurance retirement plan. Not all life insurance retirement plans are created equal, the devil's in the details just like with marriage. You don't want to get 10 years or 15 years into it and realize that you've got skeletons in your closet because a divorce from a wife can be painful but a divorce from a life insurance policy can likewise be painful. There are surrender charges, there are things like that. You want to make sure you get it right from the very start and that's why I wrote Look Before You LIRP. I want people to know that there's a whole laundry list of things that you should be looking for, one of the most important of which is the loan. That’s the preferred loan. I really recommend you take a look at page 36 in Look Before You LIRP, having the wrong loan provision can really, really sink your ship.
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Now there's another type of loan that relates specifically to a type of life insurance retirement plan called indexed universal life, it's called a participating loan. What happens with the participating loan is you have the same sort of thing on the loan side, you ask the insurance company for a loan, they send you the $100,000, they might charge you a slightly higher rate of interest, say 5%. But the good companies will guarantee that number will never change. Then in the same breath, they will likewise take money out of your growth account and put it in a loan collateral account but that loan collateral account, instead of growing at a fixed rate of interest, will grow at exactly the same rate of growth as whatever your index is inside your indexed universal life are growing. Remember how those grow, the insurance company will give you the growth of that index say the S&P 500 up to a cap, a traditionally 13% or so and then in a down year, in other words, should the S&P 500 go down at any given year, they will simply credit you a zero. Historically, these indexes have grown at 7 or 7 ½% percent, if you can get 7 to 7 1/2% growth without taking any more risks than what you are accustomed to taking in your savings account, I would say that's a pretty safe and productive way to grow at least a portion of your assets.
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Let's say that you are being charged 5% in your loan account but you’re indexed 10% that year, that means 10% positive plus a negative 5%, means that you just got paid by the life insurance company 5% for having taken that loan that year. Now, what's the flip side? The flip side is if they’re charging you 5% and you’re indexed to zero that year, then you just paid 5% to take that loan. The way we look at this is we say, “Are we more likely to have more positive arbitrage or more negative arbitrage over time?” We are looking at 2 to 3 down years in any 10-year period historically which gives you 7 to 8 up years in any 10-year period. I feel perfectly comfortable and the Monte Carlo simulations bear this out saying that if you were to illustrate a 1% arbitrage growth rate over time, in other words, if they're charging you 5%, then that loan collateral account is growing at 6%. I think you can probably get away with the 7% so where there be a 2% arbitrage, but I think at least 1% is eminently realistic and eminently doable.
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That is the participating loan. There are a couple of bugaboos here. There are some companies on the loan side where they will charge you 5% but reserve the right to change that as high as 10%. You want to find a company with a charge of 5%, it stays at 5% and is guaranteed to never be worse than 5%. Could you imagine that if you got a situation where they were crediting a 7% on the loan collateral side but they were charging you 10%? That’s a 3% net cost of borrowing which can really sink your ship over time.
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In summary, there really are two types of loans. There’s the standard/preferred loan, we really want the preferred loan which doesn't really start until after the 6th year in most contracts, sometimes after the 10th year in some contracts. That’s sort of the conservative way to go. That’s the guarantee that you'll always be able to stake tax-free and cost-free distributions. You get smaller distributions because you don't have arbitrage working for you. If you take a participating loan, you can experience arbitrage which means they may be charging you 5% but they're crediting you 6% or 7% so that’s a 1% to 2% arbitrage and then at effect is that over time, you could easily double your distribution. So while it's not guaranteed, there's a little bit of risk there, there is an upside and the upside is that you can take double and some cases triple, what you might take through that preferred loan scenario. It depends on what type of risk you’re willing to take, how many guarantees you want in your retirement plan and what type of upside you believe you can get through the participating loan.
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Those are the two types of loans. Learn more about the standard/preferred loan in The Power of Zero, but if you really want to sink your teeth into the participating loan and what it means to have a good policy that you want to ride off into the sunset with, then certainly get a copy of Look Before You LIRP, dig into it and of course, if we can help you in any way understanding things better, go to davidmcknight.com, happy to answer all your questions. Thanks for being on the show today. We will look forward to chatting with you next week. Thanks, everybody. Have a great day.
