June 29, 2008

"10-8" Leveraging: Creating Tax Deductions

Here's a special offer. For $10 you get an $8 gift certificate. Buy as many as you want.

No takers?

Okay. Give me $5.50 and I'll give you the $8 gift certificate. So you make $2.50 each time. How many do you want now?

This insurance strategy is generically called "10-8" leveraging and used by wealthy Canadians personally or through their private corporations. You get tax deductions while
  • investing the way you normally do
  • reducing the risks of leveraging through insurance
  • increasing the size of your estate
For over 25 months, most of the requests I get have been about "10-8" leveraging. I've done dozens of seminars to attendees from across Canada, trained advisors, met clients, and learned how to make the concept simpler without being simplistic. The appeal is greatest in Alberta, where tax rates are lowest (which reduces the value of the tax deductions). Ontario gets more active each month. Let's explore.

Normal Financial Leveraging
With conventional leveraging, you pay interest and perhaps some of the principal. You face two unknowns:
  1. market risk: what your investments earn
  2. loan risk: what your loan costs (often fluctuates with the prime rate)
You can't eliminate the market risk but you can eliminate the loan risk with insurance.

"10-8" Leveraging
With insured leveraging, your investment loan costs 10% before tax savings. With a marginal tax rate of 45% (say), you get tax savings of 4.5%, which reduces the cost of the loan to 5.5% after tax savings. Here's the interesting part. Your collateral earns 8% tax-sheltered. So your after-tax cost is 5.5% less 8%, which is -2.5%. A negative cost is a gain. You pick up 2.5% from leveraging.

If you earned 7% before, now you earn 9.5% using the same investment dollars. What if your focus is protection instead of investment? Use the tax savings to reduce the cost of your life insurance below market rates.

The loan becomes a source of income.

What's more, the pretax loan cost of 2% (10% less 8%) is generally guaranteed for life. That's a big advantage over conventional borrowing. When the spread is guaranteed, you want to borrow at as high a loan rate as possible. If you could borrow at 20% , your collateral earns 18% tax-sheltered. Your tax savings double to 9%, giving an after-tax cost of 11%. And a 7% gain from leveraging.

Tax-sheltered Growth
How do you get tax-sheltered growth, using Pink Floyd's insights? By putting cash into universal life insurance policy --- if you like the limited investment choices.

How can you have both the benefits of investment flexibility and tax-sheltered growth? With "10-8" financial leveraging using a specially-constructed universal life insurance agreement.

10 - 8 = 2
There are two types of "10-8" leveraging: policy loans and external collateral loans. The 10% loan interest is paid as follows
  • 2% at the beginning of the year to the insurer
  • 8% at the end of the policy year to you (your reward for borrowing from yourself)
There's a fundamental difference in the level of tax deductions you can get.
  • policy loans: pay 10% to deduct 10%
  • external loans: pay 2% to deduct 10%
With external loans, you refinance the 8% at the end of the year by taking another loan. This increases your tax deductions, which is what you and your accountant want. As you'd expect, nearly everyone who qualifies picks this version when dealing with a knowledgeable advisor who has access to both types.

Since your loan collateral earns 8% inside a tax-sheltered vehicle, you're getting a nice return. Since you actively invest outside of life insurance, you eliminate both drawbacks we discussed last time.

As you know, there are advantages and drawbacks to financial leveraging. Using insurance reduces the risk by guaranteeing a 2% loan cost before tax savings turn borrowing from yourself into a source of income for you. Using insurance also provides a larger estate than conventional investing. All the while, you're getting tax deductions.

Can you see the appeal of "10-8" leveraging?


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