Episode 3 of the Infinite Banking Concept Series - How Policy Loans work and what is the Adjusted Cost Basis?
Let’s look at a Whole Life Insurance Policy Illustration that's correctly set up for the Infinite Banking Concept.
In this illustration with a Canadian life insurance company, the client is depositing $100,000 dollars per year for 10 years.
This illustration is based on a 45 year old male who makes blogs for a financial company. These numbers will change depending on your age and if you’re male or female, but the general concept is the same for everybody.
In this case, we’re putting in $100,000 per year for 10 years and then never contributing another dollar to the policy.
Guaranteed Values
There are 2 sides to this illustration – you have the Guaranteed Values on the left side and the Non-guaranteed Values on the right side.
We’ll start with the first column Required Annual Premium – this is the minimum amount you have to put into the policy to keep it in force.
You can see in the next column that there’s also a Guaranteed Cash Value and a Guaranteed Death Benefit column.
Everything you see on the Guaranteed Values side is 100% guaranteed in the contract by the insurance company. This is your worst case scenario when setting up a high cash value whole life insurance policy in Canada. It assumes that you only ever put in the minimum premium amount and that once you set up the policy, the company never pays a dividend ever again.
Now, not paying a dividend is unlikely to happen and if one of these Canadian insurance companies ever didn’t pay a dividend into their participating whole life policies there would be massive problems and people would probably pull a lot of money out of that company.
All the companies that we work with to set these policies up have been paying dividends every single year for more than 100 years and have never missed.
Now we are not allowed to promise you that they will pay a dividend in the future, but it would be disastrous if they didn’t. Something would have to go really wrong.
We don’t spend too much time on the guaranteed values, but you do need to know what they are there. Some insurance companies use their higher guaranteed values to try and sell policies but we don’t really go for that pitch. We focus more on the other side which is much more likely to happen.
Non-guaranteed Values
On the other side you see the Non-guaranteed Values. This shows what would happen if you put in the maximum premium deposit and the company paid the same dividend as it’s paying today, forever.
In this case you can see the Cash Premiums of $100,000 being paid for 10 years. You can see the Annual Dividend you would receive after the first year, the Total Cash Values after the first year and the Death Benefit.
The Total Cash Value number is important because it’s what you would receive if you ever cancelled this policy. The Total Cash Value is also what all the lending is based on whether you are getting a policy loan from the insurance company or getting a loan or line of credit from a 3rd party lender like a bank.
What we do that’s very different from the majority of other advisors in Canada is structure the policy so that it has the maximum Total Cash Value as early as possible – in this case it’s the $86,000 number. If you were to set up a policy like this with a more traditional advisor that first year cash could be $0 or the policy could have significantly less cash values than what I’ve shown here.
You’ll see in the 2nd year your Annual Dividend goes up, your Total Cash Value goes up and the Total Death Benefit goes up. What’s happening is your premium is buying more insurance, the dividend is buying more Paid up Additions – which means it’s buying more permanent life insurance death benefit which gets you more dividend which gets you more life insurance which gets you more dividend. You can think of this similar to a DRIP program on a dividend paying stock.
Policy Cross-over Point or Break-even Point
You can see that the policy Total Cash Value has a "cross-over point" or "break-even point" in year 5 where you’ve put in $500,000 and you have more than $500,000 available in cash value. From here the Total Cash Value really starts to take off.
Risk and How You Lose Money
The big risk on these policies comes in the early years. The worst thing you can do is set one of these up and then cancel in the first couple of years.
If you set this up today and then 1 year from now you decide you don’t like it and want to cancel it is absolutely guaranteed that you will lose money - in fact, you will lose $14,000 in this example.
And if you cancel in year 2, you will have deposited $200,000 and your Total Cash Value is $180,000 so you would have a guaranteed loss of $20,000.
So if you are thinking about these types of policies in the short term, don’t do it. If you think you will have to cancel this for any reason in the first few years, don’t set it up – go do something else with your money.
Also, selfishly, we don’t want to do all the work of setting one of these up for you and then you cancel the policy. These policies are called "whole life insurance" for a reason – the expectation is that you will keep this for the rest of your life. This is definitely not a short term thing.
Policy Offset
In year 10 you can see that you’ve put in $1 million and you have $1.2 million in total Cash Value and $3.7 million in life insurance Total Death Benefit that would pay out to your beneficiaries if you pass away. If you did it right, you’ve used the cash values all the way along to hopefully build more investments outside the policy.
This policy example is offset after year 10. You can see that the Cash Premiums is $0 from year 11 until forever. What this means is that the dividend you are receiving and your cash values are big enough to cover the Minimum Required Premium of $37,000 from the column 1.
Here you don’t need to put in any additional money and the policy can sustain itself. You’ll also see that the cash values continue to compound and your death benefit continues to grow for the rest of your life as the Annual Dividend continues to pay into your policy.
Whole Life Insurance Policy Loans
The Policy Loans – What are they, how do they work?
Policy loans on whole life insurance are a key way of using the cash values in your policy and they are one of the key parts of the Infinite Banking Concept.
A policy loan is as simple as it sounds, it is a loan you take out against the cash value of your policy.
You will take this policy loan directly from the insurance company that you set up the policy with. In fact, it’s guaranteed in your contract that if you ask for a policy loan the insurance company will give it to you. Most insurance companies in Canada will lend you up to 90% of the Total Cash Value in your policy.
So in our example, you could get a policy loan of 90% of $86,000 after year 1 and a policy loan of 90% of $180,000 after year 2.
We usually recommend clients don’t take a policy loan for at least 12 – 18 months after setting up the policy. This gives your policy time to grow. It’s like planting a seed – you don’t expect to plant a seed and harvest and eat the fruit the next day. You need to let it grow before you try to chop it down. Technically with most companies you can take a policy loan right away once there’s cash values in the policy. There is one company that won’t allow policy loans until after 12 months.
Policy loans are the easiest type of loan you can get. It’s not like getting a loan from a bank where they run your credit and ask you what the money is for and decide if they are going to give it to you.
With a policy loan you literally fill out a 1 page form telling the insurance company how much you want and whether they should direct deposit it to you or mail you a cheque. Once you send in the form you will get your money within 2-3 business days if it’s direct deposit and 7-10 business days if they are mailing you a cheque.
Nobody checks your credit and nobody asks you what the money is for. And it’s a private loan so it doesn’t show up anywhere like a credit report.
I use policy loans all the time. The last couple of times was to buy a car and to pay for renovations on my house. Clients of ours use policy loans for all sorts of things like investing in the market, buying real estate, expanding their businesses, paying for kids schools and one family who uses their policy loans each year to pay for vacations.
The great thing about using cash values and policy loans like this is that the money inside your policy never leaves your policy. So it continues to grow with the dividend. You never interrupt the compound growth of your cash values.
Using Life Insurance Policy Loans to Invest
If you’re using policy loans to invest it’s even better – because if you make profitable investments you can earn in 2 places at once off the same dollar – you earn the dividend in the policy and you earn whatever you make off your outside investments. And if you talk to your accountant you can ask about deducting the interest on the loan that’s used to invest. I can’t give you tax advice but your accountant can tell you if you can write off the interest when using borrowed money to invest.
A few things that come up all the time regarding taking policy loans.
Do You Pay Interest on Life Insurance Policy Loans?
The first thing people ask is do you pay interest on a policy loan. The straight answer is yes. The interest rate is set by the insurance company each year around the same time that they announce the dividend.
The next thing people say is why would I borrow my own money and pay interest. I could just pay cash.
Yes you could do that. But whatever cash you are paying is immediately out of your control when you give it to whoever you’re buying from. And that cash is also no longer earning you anything.
With policy loans, your cash stays in the policy forever, under your control and continues to compound with the dividend. Yes, you have to account for the annual interest, but personally I think the uninterrupted compound grown of the cash is totally worth it.
People also ask do I have to pay the loan back. I say to look at your cash values as a line of credit – for compliance reasons it’s totally not a line of credit, but it functions in much the same way. If you want to use the money again, you should pay it back. Take a loan, pay it back, take another loan, pay it back and keep doing this for the rest of your life.
You’ll see some videos online saying you don’t have to pay back the loans and one day the loan amount plus any interest accrued will just come out of your death benefit when you pass away. This is technically true but it’s stupid. Why would you do this? It's much more valuable to have the funds available to use repeatedly rather than fund this policy, take 1 loan and never be able to use the cash values again.
We highly suggest you pay the loans back. In the infinite banking book, Nelson Nash calls this being an honest banker. You’re lending yourself money, you should be happy to pay it back.
Another huge advantage of taking policy loans is that you control the repayment terms. The insurance company sets the annual interest rate, but you set how much and how often you are going to pay it back.
You can pay it back in a lump sum, you can pay it back monthly, you can pay some now and more later. For some of our clients who invest, maybe they don’t pay anything right now while their money is invested and then they pay off the whole thing when they cash out.
Again, this type of loan is very different from taking a loan from a bank. With a bank you have to pay them back every month, if you’re late it affects your credit, you definitely can’t tell a bank that you’re not going to pay them back anything this year. With a policy loan from an insurance company you have so much more control and nobody calling you asking for payment.
As you can tell I like policy loans.
What is The Adjusted Cost Basis ACB of the Life Insurance Policy?
Now we’ll talk about the ACB of your policy or the Adjusted Cost Basis
This doesn’t get talked about a lot in any of the hundreds of videos on infinite banking that I’ve seen out there. It might be because a lot of the content is American and their rules are a little bit different than ours here in Canada.
In the US their policy loans are always tax free. This is not the case in Canada. Here in Canada our policy loans are mostly tax free but can become taxable.
In Canada, your policy loan can become taxable once it’s larger than your policy’s Adjusted Cost Basis or ACB.
The way the insurance is set up, the ACB of your insurance policy will start high and will reduce over time to eventually grind down to $0. Depending on your age, this "ACB grind" could take somewhere from 25 – 40 years.
The ACB curve is very similar to a mortgage payment curve – it starts high and then goes down over time.
So in the early years of your policy, all of your policy loans will be mostly tax free. And in the later years of your policy, the policy loans may not be tax free. I can’t really give exact specifics here because it will really depend on the policy, how much premium you’re depositing, your age and how the policy is structured.
So what do you do about this? Well, you want to make sure that if you’re setting up a life insurance policy to have high cash values, you work with someone who knows what they are doing and that is going to be there with you for the long term.
When you want to take a policy loan, talk to your advisor and find out your updated ACB at that time. One company has a client portal where you can login and see your values, but most don’t.
When your policy ACB starts going down, the work around to keep your loans tax free is to start taking loans from a 3rd party institution like a bank.
So in the early years you take advantage of the easy policy loans from the insurance company and then in the later years of your policy you would use the cash value in your policy as collateral to set up a loan with a bank. Taking loans from the bank would keep your loans tax free.
Now this last part – taking loans from a bank – is getting away from the pureness of the infinite banking concept as laid out in the book by Nelson Nash. In the official book, you’re supposed to hate banks and take them down by working only with the insurance company, but here in Canada we have to do this in order to keep the tax free nature of the loans. Our policy loans are not tax free every time like they are in the United States.
Your next step is to check out video 4 in the infinite banking playlist that is all about why infinite banking is a scam and why you shouldn’t do it.
If you haven’t seen our last two blog posts, we recommend going back and reading those as well.
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