Tax-Advantage Opportunities With Cash Value Life Insurance
by Peter Katt
As is commonly known and often expressed in my column, life insurance has exceptional income tax characteristics. The cash value build-up is free from any income tax consequences, and death benefits are entirely free from income taxes as long there hasnt been an ownership transfer-for-value.
This article highlights three situations where the tax advantages can benefit you.
The strategy of using life insurance for the dual purpose of protection and investment (savings) has a variety of names and in principle has considerable merit.
But for the same reason two glasses of wine a day should not be confused with two bottles daily, prudence should be the hallmark here. Unfortunately, I have seen too many situations where individuals have been pressed to convert tax-deferred assets or divert tax-deductible qualified plan contributions to life insurance premiums because cash values are tax-deferred. This is highly inappropriate.
However, there are many high-earning individuals in their 30s or 40s who have maxed-out their tax-deductible contributions, and yet still are net savers and investors.
For these individuals, such a strategy can be appropriate. First, it is necessary to determine how much family-protection life insurance is needed. Then, it should be determined how much saving and investment is desired over the medium term and long term.
Lets say Tom (age 40) needs a life insurance amount of $4 million for family protection and his medium-term savings budget is $30,000 a year. The minimum initial death benefits for a $30,000 premium are $1 million. So, Tom could buy $3 million of 20-year level-term insurance and either a wholesale-priced whole or universal life $1 million policy with premiums of $30,000 a year (wholesale-priced minimizes the commissions and maximizes Toms yield). Under this strategy, Tom could make withdrawals up to the cost basis of the life insurance for a variety of reasons, including to supplement his retirement income, with the remaining death benefits continuing to climb as an inheritance for his heirs. This entire package is free of any income taxes. Or, he could take tax-free loans from a universal life policy in excess of the cost basis tax-free as long as this is professionally managed to stay clear of problems, with the smaller remaining death benefit going to his heirs tax-free. This dual use of life insurance is a wonderful strategy as long as it is sensibly constructed.
Unneeded Life Insurance
Insurance agents and life settlement firms trying to convince clients to sell their policies are constantly referring to the concept of life insurance that is no longer needed. And this may become a dominate idea if the estate tax is permanently repealed, or compromise reform significantly lowers estate tax costs.
However, what needs to be considered in both situations is that life insurance that is no longer needed might be wanted if policyowners had a better understanding of how flexible and valuable life insurance can be.
For example, Sam and Ida purchased a $5 million second-to-die policy 10 years ago (ages 55) because of an estate tax liquidity situation. Three years ago they sold the family business and now there is no liquidity problem. The $5 million universal life policy is underfunded and their original target premiums of $46,700 have been recalculated to $105,000 a year, which is an uncomfortable amount for them since they have done considerable gifting and other estate planning strategies that have left them with less income than they otherwise would have. Sam and Ida have had some health issues since purchasing the policy, but nothing major.
The current cash surrender value is $569,000. An insurance agent obtains a life settlement offer of $725,000 that will net them $621,800 after taxes. Neither Sam, nor Ida nor their trust needs the sale proceeds that will simply accumulate and then be distributed to their heirs. Sam and Idas policy can be reduced to its minimum death benefits (around $750,000) with no future premiums. Death benefits will increase as the cash values increase. Even with somewhat compromised mortality, Sam and Ida have a joint life expectancy of 20 years. Based on the policys current pricing the yield they can expect in 20 years from the death benefits, measured from the $621,800 net offered purchase proceeds, is about 5.1%, which is income-tax-free life insurance proceeds.
If they sell the policy, they cant possibly earn this kind of return using equally safe savings instruments because these earnings will either be fully taxable or will be tax-free but with a much lower yield.
The income tax advantage of life insurance makes it a much better asset once it has been restructured than selling to a life settlement firm. I define wanted life insurance as an asset that can perform its objective more effectively than alternatives, which for Sam and Ida is to provide the maximum value to their heirs via their life insurance policy without further premiums.
Tax-Free Bond Alternatives
Sometimes it makes sense to consider using paid-up participating whole life as an alternative to tax-free bonds. Tax-free bonds, of course, make sense when their net yields are better than the aftertax yields of taxable fixed-income instruments with comparable maturities and credit ratings. My firms own calculations for a client in this situation indicated that, from a historical perspective going back 20 and 30 years, paid-up participating whole life would have provided 200 to 300 basis points better performance (measured from the time of purchase until the end of the insureds life expectancies). The life insurance yields are a bit better if death occurs before life expectancy and a bit weaker if after life expectancy. Since the life insurance company we used for this analysis has the highest financial strength ratings, our comparison was with top-rated tax-free bond yields. The life insurance yields will depend on future interest rates because the dividends will vary year-to-year. We assumed individual bond issues are used and therefore held for a long period, but with repurchase rights for the issuer. The tax-free earnings of paid-up life insurance give it a built-in advantage, since its yields are closer to taxable bond returns. That said, generally the life insurance alternative protects against interest rates being higher, on average, in the future, and tax-free bonds protect against interest rates being lower, on average. For this reason, I would not recommend that all funds allocated to tax-free bonds be instead diverted to paid-up life insurance. Perhaps 25% to 50% would be a prudent diversified position.
Existing tax-free bonds could be liquidated to invest in paid-up life insurance if there is little or no gain on their sale. Paid-up life insurance policies will be deemed to be modified endowment contracts, with earnings taxed first on cash withdrawals or loans. Therefore, if you use this strategy, you should have no intention of using the funds for your own benefit. Rather, this is a class of assets that will pass on to your heirs.
Whether the paid-up life insurance should be in an irrevocable trust or similar entities depends on whether the tax-free bonds are estate assets or outside. Treat paid-up life insurance in the same manner and dont move it off to a trust as a knee-jerk reaction to it being life insurance.
Working Through the Numbers
There are many financial advisors, CPAs and consumer advocates who believe term insurance is the only legitimate life insurance. I believe this is shortsighted, as my examples here suggest.
You will benefit more from life insurance planning that is well thought out rather than a simple knee-jerk reaction that doesnt run through all of the possibilities.
Peter Katt, CFP, LIC, is sole proprietor of Katt & Co., a fee-only life insurance advising firm located in Kalamazoo, Michigan (269/372-3497); www.peterkatt.com.