Designing the Bomb Shelter
Our last article described a “bomb shelter investing strategy” using an investment life insurance contract.
Recapping this strategy, clients build a bomb shelter by investing into an investment life insurance (whole life) contract. These contracts cannot go down in value (that is the bomb shelter). With this strategy we can generate a tax sheltered, 4-5% net rate of return while still accessing up to 90-100% of its value without sacrificing returns!
In this article will focus on how we design these contracts.
Creating the Tax Shelter
To create a tax shelter, we must have a death benefit on the contract (it’s life insurance). Four factors help us determine the amount of death benefit:
- Firstly, determine the death benefit required for your situation using a needs analysis.
- Secondly, the amount of the death benefit determines the minimum deposit required.
- Moreover, the death benefit amount determines the total amount of additional cash we can deposit into the investment/tax shelter.
- Finally, the death benefit does act as an investment tax-shelter within itself.
At this point, we need to look at the efficiency of the asset. What does that mean? To demonstrate we will use an example of a wealth building contract from Sun Life.
In our first year we deposit $100K, resulting in a year-end investment balance of $86K. You may be thinking this makes it a bad investment, but you would be incorrect. As the advantage of this strategy is in the value of:
- The tax-free death benefit
- Creating a tax shelter
- Focusing on mid to long-term returns, with the ability to access cash in the short-term
A more accurate assessment of this investment is to subtract our initial deposit ($100K) from the year ending investment balance ($86K). The difference of $14K is our cost to purchase the death benefit which ultimately gives us the tax-shelter. Shown in the table below, this $14K buys us a $2.3M death benefit.
Next year we contribute another $100K to our balance of $86K, which should give us an investment balance of $186K. As seen in the table below, however, our year-end investment balance is $184K (a difference of -$2K).
This $2K is the final “cost” to buy the $2.3M death benefit (this creates the tax shelter). This comes to a total cost of $16K ($14K in the 1st year and $2K in the 2nd year).
In our 3rd year, we make our deposit of $100K to our balance of $184K, which should give us a balance of $284K. This time, however, our year-end investment balance is up to $290K. Resulting in a net surplus of $6K. While we started with a $16K deficit, we now only have a $10K deficit.
At this point we have now purchased our death benefit. Now for each year moving forward, our year-end investment balance will increase larger than the $100K we put in.
If we continue making our $100K deposits, we reach our break-even point in year five.
|Year||Deposit||Investment Value||Difference||Total Deficit||Death Benefit|
This means our investment value is equal to or greater than what we have contributed. In other words, we have generated enough rate of return to eliminate the initial deficit of $16K. We now have a “free” tax-shelter, and a “free” death benefit.
From this moment forward our investment balance grows greater than our annual deposit of $100K. We now have the option to continue making deposits (the minimum plus the optional) or let the tax-shelter generate the minimum deposits itself. We can do this for the length of the contract.
BONUS: for illustration purposes, we’ve stated the death benefit remains the same. However, for most contracts we design, it (the death benefit) increases, so your gift increases with time.
The Importance of Contract Design
The next thing we need to identify is how flexible we can be with the deposit schedule. This will depend on which investment life insurance carrier you work with.
Some carriers will mandate the additional deposit occurs in the first year. Others will give you up to two 2 years to make the additional deposit before you lose the ability to make it. Some insurance carriers will let you make the additional deposit at any time. Others will have provisions that we can make the full contract deposit schedule over only three years.
The moral of the story: there are nuances to each contract and how each insurance carrier allows their design. Such as the length or number of years of deposit schedule (3 years, 5 years, 10 years, etc.). As well as how and when to make the additional deposit options and forecasting future anticipated returns, as this could adjust your minimum deposit schedule.
So how do you look after yourself? By working with an independent advisory firm such as Elementus Wealth to build your plan that is structured for you.
These contracts/investments are very conservative in nature and written with conservative carriers. But some carriers, typically with shorter track records, will illustrate unlikely rates of return. Our job as professionals is to audit each of these contracts. We do this by planning for the worst, such as the contract having a lower rate of return than advertised. Checking that the math still works is an easy way to keep you protected. In the case the contract outperforms the illustrations, everyone wins.
This makes it important to work with a professional familiar with these contracts. After designing these strategies for over 14 years, we understand them inside and out.
How do I know if this strategy is for me?
Give us a call. At Elementus Wealth our expertise is advising entrepreneurs to achieve a bigger impact.
We look forward to chatting.