In my recently released book Look Before You LIRP, I make the case that starting a life insurance retirement plan is a long-term proposition, and not a decision to be undertaken haphazardly. In fact, finding the right LIRP is remarkably similar to finding the right spouse. There’s a good chance that you didn’t marry your spouse after the first date. In fact, you likely had a laundry list of things you were looking for in the right partner. I would make the case that you should likewise have a laundry list of things you’re looking for in the right LIRP. After all, all LIRPs are not created equal. You must “look before you LIRP!”
In my book, I argue that finding a LIRP with the right loan provision should be at the very top of your laundry list of qualities. Why? Well, all LIRPs are tax-free, when the money is taken out by way of a policy loan, because loans aren’t construed as taxable income. But, not all LIRPs are cost-free. To understand why, let’s take a look at the mechanics of a policy loan.
Taking a tax-free distribution from your LIRP might work in the following way. You call up your life insurance company and say, “I want to take a $10,000 loan from my policy.” The company then takes $10,000 out of your cash value and they put it in what is called a “loan collateral account”. It’s important to note that your loan collateral account is still a part of your policy. In other words, the money never leaves your “bucket.” That loan collateral account bears a rate of interest, in this case we’ll say 3%. In the very same breath, the company cuts you a check for $10,000 from their own coffers, and that’s what you receive in the mail in 3 to 5 business days. In order for the loan to be an arm’s length transaction per the IRS, the life insurance company must charge you a rate of interest. In this case, we’ll say 3%.
So, if what the company credits your loan collateral account (3%), and what they charge you for the loan (3%) all add up to zero, then you have a tax-free and cost-free loan. However, some companies may start you at 3%, but reserve the right to change that loan charge to 4%, 5% or 6% at their leisure. For example’s sake, let’s say that your company decides to charge you 5% for your policy loan. Well, if they charge you 5% and they credit you 3%, then your “net cost to borrow” is 2%. And, if you don’t pay that 2% back at the end of the year, it gets deducted from your policy’s cash value.
A 2% net cost to borrow doesn’t seem like a big deal. In fact, I’ve heard financial advisors say, hey, I’d rather pay a 2% loan charge than pay a 25% tax. Well, not necessarily. 2% doesn’t seem like a big deal, but it’s a recurring expense, and that loan interest can add up quickly. You see, if you take another 2% loan the second year, the interest begins to compound because you still haven’t paid back the loan from the first year. So, now you owe loan interest for 2 years. And so that story goes, year after year, until you arrive at the point where your cumulative loan interest overwhelms your cash value, and your policy runs out of money. In fact, I’ve seen instances where a 2% loan provision can cause a policy to run out of money 11 years faster than a policy with a 0% loan provision. In that case, not only do you lose out on all the loans you could have taken had you had a 0% loan provision, but you also face the prospect of an enormous 1099 in the year your policy goes bankrupt.
In short, if you plan on taking money out of your LIRP by way of a tax-free loan, it’s imperative that you understand the legalese that describes your loan provision before signing on the dotted line. If your net cost to borrow is 0%, that’s a great start. If the company guarantees that 0%, even better. Just remember there are as many loan provisions as there are LIRPs on the market. Life insurance companies don’t follow a template when designing their loan provisions. All LIRPs are not created equal. If you want to ensure that your loan provision will contribute to a fruitful, long-term LIRP partnership, it’s absolutely critical that you look before your LIRP!