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.