For many years, especially when the estate tax exemption was low, the focus of estate planning strategies with life insurance often shifted to how the minimum premium can be leveraged for maximum death benefit. With the 2017 estate tax exemption at $5.49M for individuals and $10.98M for married couples, the time may be ripe for the planning pendulum to swing back towards a balance between securing the proper amount of death benefit and the opportunity for cash accumulation in permanent life policies.
One of the reasons why sophisticated buyers find these policies attractive is the potential to accumulate cash value that can provide another source of income to meet their retirement needs. Of course, the need for death benefit must be established first and foremost, along with other savings vehicles such as (taxable) 401(k)s and/or other qualified planning opportunities are ordinarily maximized before considering additional savings vehicles, such as cash value life insurance.
Nevertheless, for high income earners in their 30s, 40s and 50s who are seeking additional ways to save and protect their family at the same time, cash value insurance can be an important planning tool.
Advantages and Basic Considerations
Permanent, cash value, life insurance policies offer tax deferral on the inside cash accumulation, tax-free withdrawals of basis and tax-free loans so long as the policy does not lapse, as well as a death benefit that is income tax-free, pursuant to IRC § 101(a).
Four important general points should be taken into consideration when using cash value life insurance:
First, any withdrawals and loans could have an impact the death benefit payable to heirs.
Second, financial advisors and their clients should ensure that the policy is not a modified endowment contract (MEC) and that it stays in force. As long as the policy remains in force until death and it never becomes classified as a MEC, policy loans remain exempt from income tax.
This makes the income tax-free nature of the policy distributions possible, as long as they are managed properly. If the policy were to become a MEC, distributions would be subject to federal income taxation to the extent of gain in the policy. In addition, if the insured is under age 59 1/2, a 10% penalty would apply to taxable distributions, including loans. Similarly, if the policy lapses, whether it is MEC or not, these distributions taxation rules could apply.
Third, the types of products generally considered for these estate planning strategies such as variable universal life and indexed universal life, are all designed to capitalize on cash accumulation.
Fourth, financial advisors and their clients evaluating life insurance for supplemental cash accumulation should consider minimizing the death benefit as much as possible, without causing the policy to become a MEC. In this regard, many insurance carriers can help with designing the kind of policy that would allow sophisticated buyers to minimize the death benefit, while maximizing the cash accumulation potential within the product.
The Value of Cash Accumulation
For many consumers who may not own insurance or only have experience with term insurance, it may seem counterintuitive to maximize the funding of a life insurance policy, while minimizing the death benefit. However, after explaining the tax deferral of the cash inside build-up and the opportunity to take tax-free withdrawals and loans to supplement retirement income, most sophisticated buyers will appreciate the potential value of permanent cash value life insurance in their overall planning process.
Focusing on what the money is for and providing case studies and stories illustrating how cash value helps is of the essence here. For example, let’s assume Jane is a 45-year-old executive who has a substantial death benefit need buys a variable universal life policy (VUL), which permits her to allocate the cash value for exposure to market returns on a variety of underlying investment options.
Jane pays $50,000 of premiums for 20 years. Rates of returns vary and death benefits vary by product. Hypothetically, with the premium pattern Jane intends to follow and assuming she is in very good health, her planned premium may allow for an initial death benefit of approximately $1,438,000, which would be paid to her beneficiaries, income tax-free, if she dies.
Of note, Jane did not buy the policy only for the need of death benefit, she bought it for the potential of cash accumulation as well. To meet her twin goals, designing the policy the right way is most important. Even though the initial death benefit is $1,438,000, the benefit increases for 20 years to accommodate the premiums without causing the policy to be classified a MEC.
Then in year 21, the death benefit no longer increases. Assuming a hypothetical 8% gross rate of return and a 7.36 percent net rate of return, the cash value of the policy could be approximately $2 million with a death benefit of close to $3.5M, resulting in a potential $2 million to supplement Jane’s other income. Of course, this is a simplified scenario (actual results will vary) to illustrate how a VUL policy could work for Jane in this strategy.
Results may vary based on actual returns and individual circumstances, so financial advisors and their sophisticated buyers such as Jane must take care to manage their policies to help achieve the desired results. Additionally, a personalized life insurance illustration should always include assumed rates of return selected by the client, the impact of 0% investment performance, and maximum guaranteed charges.
Nonetheless, the story highlights the flexibility offered by the additional source of retirement income in cash accumulation life insurance. The cash value could be used to help pay off a mortgage, go on a cruise, or help offset unexpected expenses during retirement such as unexpected health care costs. Whether the cash is used for leisure, general outlays or extraordinary expenses, or not used at all, having the cash available is the part of the story that really resonates with many sophisticated buyers.
Insure With the People You Trust
For many of you who have never owned permanent insurance or who may only have experience with term insurance, the story of cash accumulation life insurance products — whether it is VUL or whole life or indexed universal life — may be brand new. That is one of the reasons why it is vital for cash value life insurance to be revisited. Contact Kasmann Insurance and let our trained life insurance experts help you navigate through the myriad of concerns, companies, and questions you may have about cash value life insurance.
A Letter from Mr. Bangs
I have been in the business of life insurance since 1972, and this is truly is the greatest time to sell cash value life insurance. It provides amazing value for these uncertain times.
This is because cash value life insurance uses the financial miracle of leveraging. Pennies can purchase dollars. More importantly, one dollar can do the work of many dollars.
Please look at this list of things cash value life insurance can do for individuals, families and businesses. I do not assume that you already know these fabulous benefits are available.
- It will take care of your family or business if you die too soon.If you says that you cannot afford the premium, how will your family or business afford you not being there.
- It will take care of you if you live too long.It can provide guaranteed lifetime income that cannot be outlived by using the accumulated cash values. Even better, this income can be paid income-tax free. Taxable income would require 20 percent to 40 percent higher payouts to provide the same “net” income.
- When waiver of premium is added, these plans are self-completing if you become disabled. Insurance company pays the premiums on your behalf.
- Many plans provide catastrophic illness benefits. That means if you have a catastrophic illness like a heart attack, stroke or cancer, you can access some of the benefits while you are alive. Some plans are designed to provide long-term care benefits in addition to death benefits.
- Many plans provide terminal illness benefits. That allows for financial plans to be put in place before the primary breadwinner dies, and helps to relieve some of the stress that loved ones endure during those terrible times.
- The benefit is paid to the named beneficiaryincome-tax free and does not have to go through probate. This allows for quick access to funds, and it also provides privacy.
- It is a great savings vehicle. Many cash value policies have, historically, provided a net, 4 percent to 8 percent, tax-free, long-term growth.
- Substantial access to the moneyis available via loans or withdrawals.
Even when interest rates declined over the last 30 years, most of the top carriers met or exceeded their projected dividend (mutual company policies) scale over that time period. Now the cycle is going in the other direction. Every current, initial illustration I review for consumers, lawyers, accountants and brokers, will probably provide the worst performance and as interest rates rise, many in-force ledgers will look better and better. I can tell any sophisticated buyers if they like what is being recommended now, they will love it in the future.
Remember, life insurance does not benefit dead people. Life insurance benefits the living.
Whether you have estate planning needs, business protection needs, or supplementary retirement needs, cash value life insurance offers great competitive advantages versus alternative financial assets. These advantages fall into three major categories: 1) Tax advantages 2) Financial and actuarial advantages, and 3) Legal and contractual advantages. These inherent advantages make cash value life insurance a financial asset that should be an important component of virtually every asset portfolio mix.
What about term life insurance? Certainly term insurance has a place in many planning scenarios where protection needs might terminate after a fixed period of time. However, because of its actuarial design, term insurance cannot offer the major advantages offered by cash value permanent insurance. Term insurance ends after a fixed number of years and only pays a death benefit if the insured dies while the policy is still in force. And term insurance is designed to terminate before the usual life expectancy of most individuals. This can create a problem if you still have certain asset protection or asset accumulation needs that will continue for the remainder of their lives.
Cash value life insurance can be designed to pay a death benefit whether you live to their life expectancy or not. Of course, permanent life insurance differs from carrier to carrier. Policies come in different flavors depending on your fact situation and risk profile. These policy types include no-lapse Universal Life (UL); Current Assumption Universal Life (CAUL); Indexed Universal Life (IUL); and Traditional Whole Life (WL). Most of these permanent types of policies offer a unique combination of features and benefits that place them in a class by themselves.
Federal tax benefits of life insurance
Listed here are a number of federal tax benefits that give a significant competitive edge to cash value life insurance versus other fixed financial assets:
- IRC Section 101(a) provides that death benefits of life insurance are generally income tax free when paid to the policy beneficiary. This is true whether the death benefit is paid to an individual, a business entity, a trust, or an estate. The death benefit can also be made estate tax free if the policy is owned by a third party (adult child) or an irrevocable trust.
- The policy can pay out tax-favored benefits to the policy owner before the death of the insured. For non-MEC policies, cash can be withdrawn from the policy tax free — in most cases — up to the adjusted cost basis (First in, First out- FIFO) under IRC Section 72(e)(5). Withdrawals will reduce the policy’s cash value.
- The policy can pay out tax-free cash to the policy owner in the form of policy loans at a stated rate of interest. Loans will reduce the policy’s cash value and may reduce the death benefit. This assumes the policy never lapses while the insured is still alive. Keep in mind that the tax free treatment of policy loans only applies if the policy is not a MEC.
- Tax-free cash value withdrawals or loans are not subject to the 3.8% passive income tax under the Affordable Care Act (ACA). Also, tax-free withdrawals or loans are not considered as income for purposes of calculating income taxes on Social Security retirement benefits. And cash value life insurance is not considered to be a countable asset on the FAFSA application for college financial aid at public colleges.
- The policy owner may receive an income tax free advance of some of the death benefit for certain long term care expenses, chronic, or terminal illness under IRC Section 7702B or IRC Section 101(g). These potential tax free benefits depend on the design of the policy which may or may not include certain long term care riders.
- Growth of policy cash values in excess of the cost basis are typically income tax deferred while they remain in the policy. However, a complete surrender of a policy, in a gain position, will have income taxes on the gain in excess of adjusted cost basis.
- A policy in a gain position can be exchanged tax-free directly to another insurance carrier under IRC Section 1035(a). Often, this exchange can result in an equal or greater death benefit, lower or no future premiums, or a combination of the both, however, there are risks to this exchange process, so evaluate all the factors before you proceed.
- A policy, in a gain position, can be exchanged tax-free to another carrier for either a deferred annuity or an immediate annuity contract under IRC Section 1035(a).
Financial and actuarial design advantages of life insurance
- Life insurance is a financial asset that is designed using the mathematical models of actuarial science. The pricing and features of life insurance are determined via present value and future value calculations over an assumed life expectancy of large numbers of deceased individuals over a long period of time.
- The policy may be structured so that death benefits have the potential to increase from year to year. Policies may be designed with different crediting methods based on no-lapse guarantees, current assumption interest crediting, crediting based on a stock index,like the S&P, or dividend assumptions from certain carriers.
- Policies may utilize certain riders for term insurance, long term care, waiver of premium for disability, over-loan protection, cash value enhancement and other features
- The life insurance industry is one of the most competitive industries in the U.S. This product, pricing, and feature competition of policy design assures that U.S. consumers have a wide variety of product types, features, and carrier financial strengths to choose from based on their personal financial and protection needs.
- Often, the present value cost of life insurance at life expectancy and beyond is the lowest method of financing a family, business, or estate protection need when compared to other fixed financial assets with taxable yield like CDs, bond mutual funds, or U.S. government securities. This is especially true in this continuing low interest economic environment.
Legal and contractual advantages of life insurance
- Life insurance is a legal contract between the policy owner and the insurance company. Any guarantees specified in the contract are legally enforceable under state law protections of all the states.
- Insurers are heavily regulated in all 50 states and are required to reserve significant assets to pay future death claims.
- The life insurance industry has established state “guarantee funds” to pay valid claims under policies issued by any carrier that are insolvent or in receivership. Insolvent life insurance carriers are an extremely rare event. Prospective purchasers of life insurance should ask for the current Comdex Financial Strength rating of each carrier with which they propose to do business. This Comdex value is a composite number based on Moody’s, Standard & Poor’s, A.M. Best, and Fitch rating agencies.
- Many states have adopted statutory law that protects policy cash values and death benefits from the claims of the policy owner’s creditors.
- Policy owners have the contractual right to assign the ownership of the policy to a new owner; the right to change the beneficiary of the policy to a new beneficiary; the right to collaterally assign the policy to offset a debt obligation to a financial institution or other legal person; the right to take a reduced paid-up policy where no more future premiums are due.
Your financial security can be enhanced dramatically with the unique financial asset of cash value life insurance. However, unlike other financial assets, its purchase is not an automatic transaction. Life insurance companies have underwriting rules and guidelines to gather and evaluate the proposed insured’s medical and financial situation. If these underwriting requirements are successfully met, a policy will be issued to the policy owner in upon payment of the premium.
John K. Bangs