Premium Advice — Turning compound tax into compound coverage

One of the most common client concerns is how to find money to fund advisors’ insurance recommendations. In previous columns, I examined two strategies to help clients in the medium- to high-net-worth market overcome this anxiety. In this column, I’ll explore how we can use guaranteed or fixed interest income to create tax strategies to find our premium dollars.

By merely repositioning how we think about interest income, some advisors are having success with what’s referred to as “turning compound tax into compound coverage.” The idea is that after taxes and inflation, there is a nominal gain in wealth on most guaranteed interest products. Since the entire interest income amount is subject to taxes, compound interest becomes, in a sense, a compound tax bill to the client. This allows the client to maintain the guaranteed income investment for diversification reasons while diverting the income flow to other needs that can multiply the value of these dollars.

Since there is so little net gain, the interest option is changed to pay out monthly or annually so that income can be used to fund any insurance needs and even out the tax bill each year. By relying on the theory of velocity of money, we get each dollar working for us to accomplish multiple goals. Let’s look at an example.

Consider a client who has a well-diversified portfolio with a decent amount of money in cash, bonds or GICs. Additionally, he or she could be one of many Canadians who have some money parked in a high-interest savings account. To keep the numbers simple, we’ll consider an interest account of $100,000 earning 4%. Let’s look at the total amount of interest earned over 20 years and the tax payable over that same period. In most cases, clients allow the interest to compound and pay the tax owing from other available income.

Sam and Marie Lucas, 50-year-old couple, nonsmokers $100,000 at 4% Marginal tax rate: 40%

Current situation: Year 1 interest: $4,000 Tax payable: $1,600 Year 20 interest: $8,427 Tax payable: $3,371 Year-end value in 20 years: $219,112 Total interest earned: $119,112 Tax payable: $47,645 Net gain: $71,467

However, if we consider inflation, the gain becomes much less. Inflation: 2% Year 1: Net gain after tax and inflation: $400 Year 20: Net gain after tax and inflation: $843 Cumulative net gain: $11,911

Alternative recommendation to pay out interest income to fund other needs: Total taxes payable if interest paid out each year: $1,600 x 20 years: $32,000 Taxes saved over 20 years versus compound: $15,645

We give up a marginal net increase in net worth and save over $15,000 in taxes. Then the question becomes, if we give up some of these marginal net worth gains, how do we benefit from spending $4,000 per year of interest income on insurance?

Life insurance This depends on the need. If the Lucases are a family of reasonable net worth, they might have concerns about estate preservation. Four thousand dollars per year could be used to purchase joint and survivor estate insurance that would pay out more than $700,000 at second death, assuming the couple paid their premiums for the rest of their lives. Or they could pay premiums into a universal life plan for 20 years and invest the funds at 4% on a tax-sheltered basis, purchasing $350,000 of coverage that could grow to well over $400,000 and allow further room to shelter money for estate growth.

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Long-term care & health insurance There are a wide variety of product structures for LTCI in the marketplace now, but in keeping with the above comparison, the Lucas family could prepay a long-term care policy in 15 to 20 years and use the interest income during retirement for other needs.

For about $4,000 annually for 15 years, they could purchase a benefit amount of $400,000 with inflation protection that will increase their benefit amount through the life of the policy. By the time they hit 75 and approach probable claim years, the total benefit amount would be above $650,000 and would continue to grow in order to meet inflationary pressures.

The side benefit of structuring their long-term care needs in a 15-year prepayment format is that they’ll have freed up their interest income to purchase personal health insurance when they retire at 65. As many companies reduce or eliminate retiree health benefits, more of our clients need to purchase this valuable coverage themselves. Depending on what their main concerns are, we could structure plans for them focused on prescription needs, dental needs, or other health concerns. With a wide range of premium options, we could build a quality plan for under $100 a month or a more comprehensive plan for over $200 a month.

Fixed income investments will always have a valued place in portfolio management. However, many clients are finding the idea of redirecting their interest income to fund other needs valuable to them. As their financial priorities become more complex, creative advisors are finding new ways to multiply the use of every dollar earned. Effective positioning of insurance products can help protect the lifestyle and the assets that our clients have worked so hard to build.

Chris Paterson is vice-president of sales for Manulife Financial.

(01/07/08)