The concept of Equity Harvesting is white-hot right now in the insurance and mortgage community. While there are sales books in the marketplace that make it sound like it's a can't-miss approach, caution needs to be taken so you can advise your clients properly. First of all, know what Equity Harvesting is. I define it as a means of removing equity from a personal residence through refinancing (or a home equity loan) where the money borrowed money is then placed in cash value life insurance.
Why cash value life insurance? Simply because if properly structured, cash in a policy can grow tax free (income, capital gains, and dividend taxes), and be removed tax free via policy loans. By properly structured, I mean that the policy is over-funded with cash using the minimum allowable death benefit that still allows the client to borrow from the policy tax free.
Let's take a common personal example to understand the mechanics of the plan.
Advertisement
IMPLEMENTING EQUITY HARVESTING
Mr. Smith is 45 years of age, married, and has a home with a fair market value (FMV) today of $235,000. He has two children and a spouse where their combined household income is $100,000 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 percent with a mortgage payment of $935 a month.
Let's also 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 percent debt to value ratio on the property).
In effect, equity is being removed from the 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. I also assumed that the life insurance policy used is an equity indexed life insurance policy with a 1 percent guarantee rate of return on the cash value annually, its growth pegged to the S&P 500 index (the returns are capped annually at 16 percent), and locks in the gains annually. I also assumed that the policy will return 7.5 percent annually (which is conservative since the S&P 500 has averaged over 11 percent for the last 20+ years).
Mr. Smith wants to retire when he is 65 years old and withdraw money tax-free through policy loans from his cash value policy from age 66-90 (that's a 25-year span). So then, the question becomes, how much could he borrow tax free from his life insurance policy starting at age 66? The answer is $23,000 each year for 25 years for a total amount of $575,000. Not bad, eh?
While $23,000 is an ample amount of money tax free in retirement for a couple whose annual taxable income is $100,000 a year the question becomes: What would Smith have done if he did not implement an Equity Harvesting plan? Probably nothing. Therefore, $23,000 a year is a significant improvement to that retirement income.
