Equity Harvesting: A Good Idea?

Today’s reading assignment: Reaping the Benefits of Equity Harvesting, which was written for financial planners and brokers but is still worth reading for everyone else.

What is equity harvesting?

The author of the article defines equity harvesting 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.” Here’s his reasoning for using 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.

In my opinion, this is nothing more than a new way to sell people more insurance. Is this a good thing?

An example

Here’s a scenario of how equity harvesting works:

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.

Call me crazy, but this doesn’t seem like that great of a deal to me. For one thing, that $23,000 he talks about is not adjusted for inflation, which will cut it’s purchasing power to about $11,000 in 20 years.

It gets even better (worse). He then does another “what if” scenario in which he looks at taking the home equity and investing all of it in after-tax mutual funds:

When investing money in the stock market, there are annual expenses. I will assume a conservative 20 percent blended tax rate (capital gains/dividend tax which is very conservative) on the growth (the industry standard is 30 percent) and only a .6 percent annual mutual fund expense (the average is over 1.2 percent). For this example, I assumed the money would grow in a brokerage account at a gross rate of 7.5 percent annually (the same rate as the funds will grow in the life policy). If Mr. Smith invested $5,737 every year in the stock market, he could remove $19,038 a year every year, after tax, from ages 66-90.

I find it a bit funny that he assumes that all the money will be invested in fully-taxable accounts. He mentioned earlier that this particular guy makes $100,000, which qualifies this guy to contribute to a Roth IRA. So, this guy could theoretically could contribute $8,000 ($4,000 for both him and his wife) per year into Roth IRAs and invest the rest in the Vanguard S&P 500 Index Mutual Fund, which has an expense ratio of .18%, which is a heck of a lot less than the .6% he uses in his example.

You can’t tell me that the client would be better off going with cash value life insurance over investing in Roth IRAs and and S&P 500 Index fund.

Finally, one other thing the author does in the article that drives me nuts is when he talks about deducting the interest on the home acquision debt (HAD):

HAD is deductible up to $1,000,000 of new debt if married and $500,000 if single (also limited by the traditional phase out deductions). Therefore, if a client has a $1,000,000 home with no debt, sells it, takes profits, and buys a new home with $1,000,000 of new debt, the interest on the new home loan is fully deductible.

If Mr. Smith had purchased a new home, removed $75,600 in equity from the sale of his old home and allocated $15,300 of that money each year to a cash building policy, then he could write off the interest on the loan. So then, how much better does Equity Harvesting work if he could write off the interest?

Mr. Smith is in the 25 percent Federal income tax bracket. If he lives in a state with a 5 percent state income tax, his combined tax rate is 30 percent. In the example, I had Smith invest $5,737 a year (the interest expense) into a brokerage account to compare doing nothing to Equity Harvesting. Now, because he can write off the interest in the 30 percent tax bracket, the actual out of pocket cost to borrow the money is $5,737 x 70 percent = $4,015.90.

If he invested $4,105.90 each year in the stock market using the same assumptions as earlier, he could take out $14,319 after tax from his brokerage account from ages 66-90. You’ll recall that from his Equity Harvesting life insurance policy, he could remove $23,000 a year after tax each year or $8,681 more per year after tax. This is the power of Equity Harvesting and why it is so easy to sell it to a client if you can write off the interest.

You see, the home quity debt that he mentioned in the beginning of the article isn’t tax deductible if…

a client removes equity from a home (refinance or equity loan) and repositions the money directly into a cash value life insurance policy with contemplation of borrowing (classic Equity Harvesting), the interest on the HED is not deductible.

So, in order for the guy in the example to be able to deduct his interest, he would have to sell his home! But, if I read his statement correctly, the HED is tax deductible if it is invested in mutual funds. Why didn’t the author mention this? It changes the whole picture and definitely makes the cash value policy route look much worse.

Finally, when he does talk about the out of pocket cost of investing in the brokerage account, which is $4,015.90, he assumes that that amount is invested rather than the original $5,737 used earlier. This is quite misleading. What happened to the $1,721 difference? Where did that money go?

If you are approached by someone who tries to talk you into equity harvesting, PLEASE do your research BEFORE you sign up.

To be continued as I have more to say on this topic but first I have to wrap my brain around it.

Here’s Money’s Walter Updegrave’s thoughts on equity harvesting.

27 thoughts on “Equity Harvesting: A Good Idea?”

  1. These insurance/variable annuity guys are indeed clever salesmen. I would suggest if these people did indeed have an interest to put their equity to work they would be better served in using Roth investments for tax deferrment and taxable account invested in Vanguard index funds.

    But why even tinker with that equity? Keep contributing yearly to their roths and 401k. The paying down of the mortgage could be another investment “hedge” for the long term.

  2. I am not in favor of life insurance as an investment. I am in favor of life insurance as insurance – the cheapest term insurance you can find, that is.

  3. Agreed, Sam. Life insurance is just that. Equity harvesting seems to put one’s home in danger (though perhaps one could get the money back? it’s a bit confusing) and not get one a good investment value.

    Did anyone else feel that the original writer is throwing around a lot of numbers in an attempt to overwhelm us and convince us that this is the way to go?

  4. jlp. good grief. another insurance related hypothetical. please tell me you’re not shilling for them. this ain’t rocket science. term life insurance. period. auto insurance. period. home insurance. period.

  5. Muddlehead,

    Did you not read the post?

    I get the idea that you think I’m in support of this strategy. I’m not. My goal is to make people aware of these products and ideas.

    Believe it or not, we are pretty much in agreement.

  6. Good post.

    But if we assume that Mr. Smith had already exhausted other savings vehicles (e.g. IRA, 401k, etc) then this might be a reasonable way to put his wealth to work.

    What do you think?

  7. You say that he could contribute up to $8000/year for the ira (him+spouse). Hopefully I’m wrong, but my understanding of the income limits ( http://en.wikipedia.org/wiki/Roth_IRA#Eligibility:_Income_limits ) is that since they live together, unless one of them makes $0/year, they cannot contribute the full amount. And over $10,000/year, they cannot contribute at all.

    Or, if you’re married, can you and your spouse each start up two “single” Roth IRAs?


  8. hiya jlp. here’s where i’m coming from. enjoy the site. try to check in daily. would love to see this become another site where financial do it your-selfers can glance and learn. afraid, though, so many annuity topics give the wrong impression – especially when annuity salespeople populate and obfuscate the responses. there are a few absolutes in the investing realm. these would cover 99% of the people reading this paragraph. don’t “trade” futures and commodities. don’t do limited partnerships. no load funds over load funds. be aware of salespersons conflicts of interest. etc… on this list is avoid annuities.

  9. There are two questions here:

    1. Should you do a cash-out refi to invest in something?
    2. Is an annuity the best investment for your cash-out refi money?

    The answer to 1 is that numerous people do it successfully, and many do not do it successfully. They invest in tons of stuff from small businesses to stocks to pretty much everything else under the sun. This is an investment question and is subject to standard investment analysis such as your risk tolerance (which should be fairly high to try this strategy), etc.

    The answer to 2 is … it’s an annuity, so it’s an insurance product. It ain’t an investment.

    The annoying thing about this whole pitch is it confuses the two questions, making it sound like Question 1, the source of the money, has anything to do with Question 2.

  10. Muddle: I like that JLP has a different site from everyone else. You can read the Standard Personal Finance Litany, or the usual “I read this article today on CNN Money/Kiplingers/whatever and here’s my extra two cents so I can have a blogpost today” just about anywhere on the web, but few people have the patience or background in finance to tackle these rather arcane and complex arrangements and dissect them in a way that normal humans can understand.

  11. I’m a bit confused Muddlehead. JLP has never endorsed annuities, rather he has highlighted the pitfalls of this type of fixed income. I for one am not very knowledgeable about these types of investment vehicles in the real world (other than to stay away from annuities), and it helps to get a bit of background information about them.

    If you read the articles, JLP is in fact against annuities (unless completely knowledgeable and even then extremely cautious), and most of the posters agree with JLP.

  12. coolio friends. we can all agree, i hope, to not buy annuities from an insurance company. ever. i have asked on this site, before, and i’ll ask again. anyone who disagrees please give me and the readers a specific example of when this product is appropriate for the buyer.

  13. Equity harvesting in the specific way it was presented using life insurance might not be a good idea. But for the right individual who can invest for the long run and achieve returns in the 8-9% while borrowing at rates in the 6-7% range should come out ahead. It is a strategy for those with a decent appetite for risk, but certainly not a strategy without merit.

    And annuities certainly serve a purpose. They aren’t for everyone, but the newest crop of Variable Annuities with “living benefit” riders have a lot to offer. Guaranteed payments for life with market participation on the upside? Of course, there is the downside. They are the most expensive products in the market. That is a big downside, and there is no hiding it. But for those who find themselves with no pension, and a 401K or IRA that they are going to try to live off of for the rest of their lives, a guaranteed income stream for a portion of their holdings makes sense.

    As a financial advisor at a big investment house, I expect this to be read by the public at large with a healthy dose of skepticism, and I can fully appreciate that. It is, afterall, healthy.

  14. A Fixed annuity can be a very suitable position for retirement funds both during the accumulation phase and during the income phase of retirement planning.

    “Equity harvesting” can also be a very suitable strategy for building a tax-free retirement income stream. However the cash value life program must be structured properly (overfunded, minimum death benefit to maintain tax favorability, and disability riders). This plan is self completing (in the event of death — death bene is paid tax free to beneficiaries, in the event of disability — disability rider continues to make payments) no roth or traditional IRA or any taxable investment or savings vehicle provides this protection.

  15. If you’d like to read the industry standard book on this topic The Home Equity Management Guidebook, go to http://www.thewpi.org/?a=PG:913.

    The bottom line is that give certain real world assumptions Equity Harvesting works fine. The problem is that the concept is for the financially stable not for everyone who happens to have equity their home.

    In the book you can see with verifiable math the difference between growing wealth in cash value life, brokerage accounts, 401(k) plans and Roth IRA/401(k) plans.


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