“What Could Prevent Me from Doing IBC?” [Part 3/5]
A discussion of obstacles to implementing the Infinite Banking Concept. Obstacle #3: “I (We) Don’t Save Money.”
I (we) don’t save money
In BYOB — and elsewhere on this blog — we learn about what Nelson calls “Parkinson’s Law.” Applied to finance, it’s the natural tendency for “expenses to rise to meet or exceed income.” Because, after all, a luxury once enjoyed very quickly becomes a necessity.
In order to build capital (which is what we’re doing with the IBC), one must have the money to do it. That means not spending all of your income.
There is a very popular three-part series of articles in the Lara-Murphy Report written by Carlos Lara entitled “An IBC Tax Strategy.” These articles suggest that the IBC can be used as a “cash-flow management system” — a title that I’ve used to describe the IBC in the past as well. Carlos uses the payment of taxes to illustrate his point. The idea is to channel as much income as possible into an “IBC-style” whole life insurance policy and accumulate cash value. Then, when the time comes, the individual policy owner takes a policy loan, collateralized by the cash value in his policy, to pay the tax bill.
This transaction has two primary results: (1) it clears the “debt owed” (whether taxes are legitimate “debts owed” is a subject for another time — let’s assume for the sake of argument that they are) with the IRS, and (2) it creates a policy loan balance (a debt owed to the life insurance company). The outstanding policy loan balance does accumulate interest, albeit on relatively preferable grounds (loan repayments go first to the principal, and interest is only added to the balance once per year).
The articles then show an individual repeating this process again in the following years. Each year, the policy owner pays his maximum premium, builds additional cash value, and takes out a policy loan from the company (collateralized by the newly accumulated cash value) in order to pay taxes. Consequently, his outstanding policy loan balance continues to grow year to year. In the illustrations Carlos shows — and they are legitimate illustrations — the cash value growth outpaces the growth of the policy loan balance. Therefore, technically and actuarily speaking, we have a legitimate cash-flow management system. Premiums are being paid, cash values are growing, policy loan balances are growing, taxes are getting paid, and on net, the individual still has a viable, growing “IBC-style” policy under his belt.
One of Carlos’ points in this series is that what the individual has done by taking the above approach is created a place to put windfalls. A windfall is just an unusually large inflow of cash, perhaps from the sale of a business asset, a home, or other property. When that significant inflow comes, it can be used to pay off the outstanding policy loan balance. With the outstanding policy loan balance that the individual accumulated in order to successively collateralize new policy loans and pay taxes on an annual basis cleared, the individual has a sizeable now-uncollateralized cash value and a substantial death benefit to boot.
Check out the illustration below. It’s from Carlos’ second tax strategy article in the February 2017 LMR.
Pay close attention to the headings of the last three columns. They are all “net” figures. That means that “Net Premium Outlay” is the difference between what the individual paid in ($120,000) and what he received in policy loan funds ($86,000). The difference is $34,000. “Net Cash Value” is the cash value that remains uncollateralized after the individual takes a policy loan. That means, for this individual, his gross cash value must have been $86,000 (the amount of the policy loan) plus $7,000 (uncollateralized cash value) for a total of $93,000. Similarly, the “Net Death Benefit” means that if this individual were to pass away with the policy loan outstanding, the amount that would go to his heirs is $2.4 million. Had the individual repaid the policy loan before his death, his heirs would receive $2.4 million plus $86,000. The reason is that the life insurance company gets paid first if the individual passes away with an outstanding policy loan balance; the death benefit literally pays off the loan. What’s left goes to the beneficiaries.
As you can see; on paper, this strategy works. That means that his net cash value remains positive. In other words, the cash value growth is sufficiently high (due to annual premium payments, interest growth, and the use of dividends to pay additional premium) in order to outgrow the policy loan balance. For example, in year six, the outstanding policy loan balance is $697,000. The net cash value in that year is $22,000. That means that this individual’s gross cash value is $697,000 + $22,000 = $719,000. As long as the cash value is higher than an outstanding policy loan balance, the policy remains in-force.
The idea here is that eventually, one of two things will happen. In case (1) the individual will pass away with the policy loan balance outstanding. Suppose he passes away in year 4. The life insurance company will be paid the outstanding policy loan balance of $438,000 and a death benefit of $3 million will go to the individual’s beneficiaries. Or, in case (2) the individual will experience some significant windfall and he’ll use that money to pay off the outstanding policy loan balance. Suppose in year 6 he sells some real estate for $700,000. That money can be used to pay off the outstanding $697,000 policy loan balance. This would cause the individual’s gross cash value to increase by $697,000 for a total of $719,000 ($697,000 + $22,000).
This series of articles has been very popular with folks. I mean, all the individual has done is rearranged his cash flows. He hasn’t worked a day harder or earned any more income than he already makes. All he’s done is changed where his money goes throughout the year leading up to tax time. When tax time comes around, he’s got sufficient cash flow to pay (in this case) his income tax that he was going to have to pay anyway. And like I said, on paper, this works.
In Part IV of Becoming Your Own Banker, Nelson shows a series of example illustrations where a logger is using his “IBC-style” policies to finance the purchase of equipment for his business. Those illustrations are a little more complex and take some study to understand, because what Nelson shows there is systematic policy loan repayment. In fact, he even says that to not repay policy loans is to “steal the peas” — a quip he pulls from an earlier example where he cites a grocer and the possibility of the theft of a can of peas.
I don’t want to ruin the lesson for you, but suffice to say that Nelson absolutely, categorically does not endorse the practice of intentionally maintaining (not repaying) a policy loan balance. Don’t get me wrong. I’m not saying that Carlos totally defies what Nelson advises in BYOB. Carlos does say that the policy loan balance should be paid down when the windfall comes in. However, we can also note that in BYOB, policy loan balances are not paid down with windfalls. They are paid with the regular cash flow from the logger’s business.
OK, what’s the point?
It is this: yes, you technically can use IBC-style policies to “manage your cash flow,” i.e. to accumulate cash value, originate policy loans, pay your regular expenses, and thereby avoid “saving” more than you already do. On paper, it works. It is not what Nelson teaches in the BYOB. Of course, when you do IBC — and this is the beautiful thing — you are in charge. If you want to run policy loan balances each year and not pay them down with regular cash flow as Nelson illustrates in Part IV, you have the contractual right to do that.
Please understand though, that if things go wrong, if for whatever reason the above-illustrated policy were to lapse with a significant policy loan balance outstanding, you would trigger a taxable event. (This isn’t tax advice, but) the taxable amount in that given year would be the difference between what you’ve received from the company and what you’ve paid in cumulative premium.
For example, in year 8, you’ll have paid a cumulative premium of $120,000 * 8 = $960,000 over the life of the policy. You have an outstanding policy loan balance of $987,000 and a net cash value of $28,000. If in that year, the policy lapsed with the policy loan balance outstanding at $987,000 and you received the net cash value of $28,000, the “taxable gain upon surrender” to the individual would be $987,000 — $960,000 + $28,000 = $55,000. As I’ve heard Carlos say, “the goal is to die with the policy in force.” If that happens, then you’ve successfully (and legitimately) avoided a taxable event.
All that is to say that this cuts things far too close. I do not advise that clients intentionally run a policy loan balance without a good idea of how they’re going to repay the loans. After all, you wouldn’t take a loan from a third party without knowing how you were going to repay it. In fact, they probably wouldn’t issue the loan in the first place. If you treat someone else’s banking system with that much respect, shouldn’t you treat your own with the same?
What Carlos shows in those articles is for illustrative purposes only. I know he isn’t trying to put IBC policyholders in a tight spot. But frankly, what he’s showing is extremely advanced — in the way that NASCAR racing is extremely advanced, and extremely dangerous, driving. It looks good when it’s done properly, and on paper, everything will work, but when you hit the track, life can happen, and things can get ugly.
Therefore, the lesson here is that in order to practice the IBC, channeling cash flow really isn’t enough. You have to have the discipline to save. My mentor James Neathery is fond of citing Jim Rohn, who said (paraphrasing) that “we must all suffer from one of two pains: the pain of discipline or the pain of regret. The difference is discipline weighs ounces, and regret weighs tons.”
