Interest deductibility and the Insured Retirement Program
The Insured Retirement Program (IRP) and Corporate Insured Retirement Program (Corporate IRP) are two insurance concepts that include a bank loan as part of the planning process.
These concepts are designed to meet the client’s need for insurance protection today and supplement retirement income in the future. With both concepts, the client acquires an exempt life insurance policy and accumulates cash value by depositing amounts into the policy in excess of what is needed to pay the policy charges. At retirement, when the policy has significant cash value, it is used to secure a bank loan, structured as a line of credit. The borrowed funds are received tax free and may be used to supplement retirement income. At death, the life insurance proceeds are used to repay the loan with any remaining amount available to the named beneficiary of the policy.
In many IRP and Corporate IRP situations, loan interest is not deductible for tax purposes.Under paragraph 20(1)(c) of the Income Tax Act, interest is deductible when it is paid or payable in respect of the year (depending upon the method regularly followed by the taxpayer) pursuant to a legal obligation and the borrowed money is used for the purpose of earning income from a business or property. In IRP and certain Corporate IRP situations (Corporate IRP – with shareholder borrowing for example) where the borrowed funds are used to supplement retirement income, this will not meet the conditions under paragraph 20(1)(c). If the client is able to structure their affairs properly and meet these conditions, interest may be deductible. For more information on interest deductibility please refer to the Tax Topic entitled “Interest Deductibility”.
If the client feels that they can structure their affairs so the loan interest is deductible, the IRP and Corporate IRP illustration software can reflect this in the output. The software determines the tax benefits associated with the deduction and factors them into the numerical analysis.
The impact of this is higher annual loan amounts when compared to a similar illustration that does not assume interest deductibility.
We are frequently asked “What assumptions are we making to reflect interest deductibility in the illustrated benefits?” This is best understood by looking at an example:
John has been shown an IRP illustration that assumes interest deductibility. The illustration shows annual loans of $50,000 starting at age 65 for 20 years. The bank loan rate is 8.00% and the personal tax rate is 45%. This results in an effective after tax loan rate of 4.40%. The outstanding loan balance at the end of the first year of loan is $52,200. What assumptions have been made to reflect this balance?
The client borrows $50,000 and invests the funds meeting the conditions under paragraph 20(1)(c). The annual interest on the loan is $4,000 and the client pays the interest. The client deducts the interest expense and realizes tax savings in the year of $1,800. At the end of the year the client borrows a new amount of $2,200 (difference between the annual interest paid and the tax savings from the deduction) and again invests the funds meeting the conditions under paragraph 20(1)(c). At the end of the year the loan balance is:
From a cash flow perspective, the IRP illustration assumes:
It is important to understand that without following these steps the client may not realize the level of IRP benefits illustrated under the concept. In any leveraged situation where interest deductibility is assumed, the client should seek the support of his or her own professional advisor.