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Retirement Planning > Retirement Investing

Harvesting Equity When Planning For Retirement

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Equity harvesting has been around for many years but only recently has come into the mainstream. The concept is simple: Borrow money and invest the funds in something tax-favorable.

My question to you is: Would you advise clients to borrow money if they could (1) get an interest rate of less than 7%; (2) write off the interest on the loan; and (3) leverage a vehicle–life insurance–in which the funds can grow tax-free and permit tax-free withdrawals at retirement?

Of course you would! From a financial standpoint, equity harvesting is a no-brainer. Where do you find a lender who will lend clients money to invest and what asset(s) are used as collateral? If the client owns a home, then you know the answer.

Mechanics Of The Plan

For brevity’s sake, we will discuss our favorite equity harvesting solution, a 1% cash flow arm mortgage program on the personal residence. The program is for clients who want to minimize monthly home mortgage payments while investing the saved money for future retirement savings. The technique is not for homeowners who aim to pay off their home mortgage in the standard 15 to 30 years.

The point of the program is to minimize current costs, which frees money for investing. The program has a 1% starting rate that stays low for five years. The payments (not the interest rate) of the arm increase at the rate of 7.5% a year.

At the end of the fifth year, or any time after the third year without penalty, the client can refinance the loan back into a 1% program. The client also can keep the going interest rate on the loan or refinance with any other loan program.

The numbers speak for themselves. Consider a client (male, age 42) who has a $400,000 mortgage on a home with a fair market value (FMV) of $500,000. Chart A shows what happens to the client’s home mortgage payments with a 1% cash flow starting rate vs. a 6% 30-year conventional loan. The amortization with the 1% arm is 40 years.

Remember, the client wants to reduce the mortgage payments to as low as possible so the saved money can be invested. With the 1% arm, the client frees up $73,395 of cash flow over the five-year window.

If the client invests the money saved from lowering the mortgage and has a return of 8%, the investment will yield $93,993 at the end of the fifth year (see Chart B). In the example, we assume the investment vehicle is an indexed annuity, which allows the money to grow tax-deferred.

Starting at age 63, the client can withdraw from the indexed annuity $28,000 each year for 20 years. (The growth above basis would be income taxed, thereby netting $18,450 a year after tax.)

If the client takes the money saved from the first five years and invests it into an equity-indexed life insurance policy earning 7.9% a year, the client can take out $22,000 per year income tax-free from ages 63 to 82. And the client has a sizable death benefit while the policy is in force.

Remember, the numbers above are only from the savings on payments from the first five years. Also note the client is writing off the interest on the loan.

Equity Harvesting Illustrated

Would a client refinance a property if he could have payments based on a 1% start rate and invest the borrowed money in a tax-favorable environment? Many would say “yes.”

Example: Assume a client has a $1,000,000 home with no debt or very little debt. Assume also the client sells the home and buys a new one; that he removes $600,000 of equity from the sale of the home and invests it for retirement income later; and that he uses the 1% cash flow program and is in the 40% tax bracket. Chart C shows what would be the interest payments on the loan for the first five years.

If the client invests the $600,000 in an indexed annuity that yields an 8% return, the numbers would look as follows at the end of five years (see Chart D).

If the money continued to grow at 8% until the client reached age 63, he could take out $296,000 each year for 20 years. The client would pay income taxes on the amount above basis in each payment. After income taxes on the growth at 40%, the client would be left with $159,000 a year.

If the client invests the $600,000 into an equity-indexed life insurance policy earning 7.9% a year, the client could remove from the life insurance policy $191,000 income tax-free for 20 years starting at age 63. (Plus the client would have a sizable death benefit to protect the family.)

The following is an example of a life insurance policy illustration based on the life of this particular example client. The illustration will obviously look better or worse depending on the investment returns. This illustration uses an equity-indexed life insurance policy wherein the growth is pegged to the S&P 500 index. (See Chart E.)

Real World Planning

When clients use this loan, they typically will refinance back into the 1% cash flow arm every three to five years. This keeps payments to a minimum and allows the maximum amount of money to be used for investment purposes.

While a client could use the money saved and invested to pay deferred interest, most clients will refinance the deferred interest (if any) into the new 1% arm. This allows the invested money to grow and be used for retirement.

But note: The client’s home is appreciating at a rate ranging from 3.5% to 10% per year–and in many parts of the country at 10%-plus per year. So, while the client’s debt could increase with the 1% program when refinancing the home, the increase in equity more than offsets this debt.

From a financial standpoint, the 1% cash flow program is virtually a no-lose proposition for clients. Payments on money borrowed start at 1%. That money, when invested, should grow at 5% to 8%.

Clients who are prepared emotionally to pay down the debt on their home because it is better long-term financially will gravitate to the 1% cash flow program. They will not only refinance current debt to free up investment dollars but will also take equity out of their homes to build a retirement nest egg quicker.


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