What if I told you there was a way to spend down your savings and still earn a yield on it? You’d probably roll your eyes and wonder when the sales pitch was coming. Clearly, there’s no way your savings could continue to earn interest if it’s depleted, right?
Well, actually. . . .
I’m about to let you in on the biggest money hack I’ve ever stumbled upon.
When I first discovered this, I convinced myself there was no way it was possible; surely I had to be missing something. Yet the more I looked into it, the more it seemed legit – then I felt like a genius. This feeling lasted long enough for me to Google it, to realize people far craftier than me had figured it out a long time ago.
They’ve put their own marketing spin on the system, giving it fancy terms like “infinite banking,” “banking on yourself,” and “living wealth,” but it’s all just different lipstick for the same pig.
Regardless of the name, the vehicle they are using is called a participating whole life insurance with paid-up additions. This is a special kind of life insurance policy, from a special kind of insurance company.
Let me break it down a bit, because each word is important.
First off, a participating policy is one underwritten by an insurance company that is owned mutually by the policyholders, rather than stockholders. This way, higher profits and savings in operating expenses go back to every policyholder as dividends and cash value increases.
Next, “paid-up additions” is a way to increase the cash value and death benefit of a whole life policy. This can be funded with dividends, or it can be paid out-of-pocket. The higher the paid-up additions, the higher the cash value and the larger the death benefit. The larger the death benefit, the bigger the share of any dividends and profit-sharing (assuming a mutual insurance company).
The policy itself has to be structured in a precise way to maximize growth of cash values without triggering what the IRS calls a MEC (modified endowment contract). Yup, participating whole life insurance is so effective in growing wealth tax-free that the IRS had to put restrictions around how much money you can stash into it.
Keep your money working for you, even after you’ve borrowed it
There is a kind of life insurance policy that keeps earning you money at between 3-5% a year, even when you have used the money on something else. It’s almost like the money never left your policy.
How is this possible?
The cash value growth that you get as a policy holder generally comes from two buckets:
- lower-than-expected operating expenses, and,
- the profits your insurance company earns.
Let’s dig into these concepts a little.
Every insurance company adds a bit of a buffer into the premium it collects, that’s how it plans its costs of running its business. The buffer is not a lot, maybe 1-2%, to cover operating expenses. If everything goes according to plan, it gets to keep what’s leftover at the end of the year.
Insurance companies owned by stock retain this leftover cash as additional profit, which goes to the stockholders.
Mutual insurance companies (which are the ones we’re interested in) return the earnings to policyholders as a dividend. In fact, they’re contractually obligated to. After accounting for costs, the remaining profit is distributed, or refunded, to active policyholders.
That’s not the only money that is paid out to active policyholders, however.
Every insurance company will invest the premiums it collects. That is, after all, how insurance companies really make their money, by investing yours. If they do really well, there is more profits to be shared. Again, if your insurance company is owned by policyholders, then a slice of those extra profits come back to you.
And here is where the magic happens: the money you borrow doesn’t technically come out of your cash value. Instead, it comes from a different ledger, the same one that the insurance company uses to invest in (and shares its profits with policyholders). So, although the cash value limits how much you can borrow, the actual loan comes from a separate account.
Who is an active policyholder?
Now, you’ve heard me talk about active policyholders. What constitutes an “active” policy, anyway?
This is usually defined as:
- Annual premiums are paid up, and,
- If there is a loan, the principal and annual interest incurred must be less than the total cash value (which grows every year).
As far as the insurance company is concerned, it is managing its risk by limiting the amount you can borrow to your cash value, and using your death benefit as the collateral in case you skip town.
This is why the insurance company doesn’t care if you borrow any money from it or not. As long as your policy is active, you will get your dividends and profit-sharing, and the cash value will grow at 3-5%.
This is also where the paid-up additions come in. Remember, the more you pay into the PUA, the higher the cash value, and the higher the death benefit. Both of these are important because:
- The higher cash value lets you borrow more from the policy
- The higher death benefit earns you a larger share of dividends and profit-sharing, as long as your policy is active.
If you put the dividends and profit-sharing back into more PUAs, and do it year after year, you end up having an accelerating, self-perpetuating wealth generator.
There is a downside to PUAs though – it’ll take a few years of paying into the policy before it gains enough critical mass and kicks into high gear. So this is not going to be a get-rich-quick scheme.
A note about insurance premiums, interest payments and tax deductions
One of my early concerns was that the interest I paid on my policy loan would not qualify as a deduction on my taxes without an actual 1098 mortgage interest statement. That was the concern my CPA had as well, but when I pressed her to dig deeper, it turns out every cent in interest paid is deductible, as long as the loan is secured against a property that is not your primary residence.
Just something to keep in mind and discuss with your CPA.
So there you have it! In essence, we’re borrowing money from our insurance policy, and still getting an “interest” on the amount. How sweet is that!