INDEXING

LIFE INSURANCE AS A TAX HAVEN

When I tell clients and their advisors that they can invest in the market (S&P 500®) and participate in the gains when the market goes up but NOT participate in losses when the market goes down, they seem skeptical. When I tell them that the gains will compound without tax AND the withdrawals can also be tax-free, they become downright dismissive. Traditional "financial planning" offers guarantees with little upside or upside with little or no guarantees. The following article will dispel a few myths and change the paradigm for how you and your clients utilize life insurance.

In February of this year, the New York Times ran an article titled "Tax-Free Life Insurance: An Untapped Investment for the Affluent." The article brought into light the aspects of investment grade life insurance that many high net worth clients are generally unaware of, yet have been around for decades. While most clients are aware that "death benefits" are tax-free to their heirs, many are discovering the "living benefits" of a correctly structured policy. Specifically, how one can maximize the tax benefits of the cash value buildup inside a policy and spend that money, free of tax, during their lifetime. In fact, this approach has really nothing to do with the need for life insurance coverage. Sure, the coverage is "coming along for the ride" but the structure described herein is purely about the favorable tax treatment of the underlying invested dollars.

Investors are facing two serious predicaments. First, saving for retirement in a "principally protected" environment (i.e. a CD) will not obtain a high enough yield to keep pace with inflation and the rising cost of living. These "savers" are forced to seek higher returns, which usually translates to exposure in the stock market. However, the world is increasingly volatile, both economically and politically, and "buy and hold" has failed many as a strategy.

Second, with astronomical deficits and government spending, rising taxes on both income and investment earnings are seemingly inevitable. Truth is, we are currently experiencing a relatively low historical tax environment. According to USA today, "Americans are paying the smallest share of their income for taxes since 1958, a reflection of tax cuts and a weak economy." One only needs to look to our country's past to discover that income tax rates have consistently averaged much higher. In the 1940's, top bracket income tax rates were as high as 94% and rates topped out at 75% in the more recent 1970's.

Top US Federal Income Tax Rate from 1913 - 2011
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Sure there were many more "loopholes" in those days however the IRS, along with the help of Congress, has done a wonderful job of sealing them shut.

A "tax-free retirement" sounds like an oxymoron but this is precisely what a correctly structured life insurance policy can provide. It is a fact that life insurance is the last financial instrument under current law that can offer essentially unlimited after-tax contributions, tax-free growth on earnings and tax-free access (via loans). As an added benefit, the assets within the policy (as well as the coverage amount) can be passed on to the heirs without tax.

CASE STUDY:

Joe has $1,000,000 to invest. He is forecasting that he can earn 7.2% annually by investing wisely. Joe's plan is to let the money grow/compound for 10 years and then begin withdrawing the annual interest earned as spendable retirement income. Now he must decide, which approach is best from a tax efficiency standpoint:

Option One: Invest $1,000,000 in a financial instrument earning 7.2% that will be taxed "as earned" (ordinary income assuming 33% tax)

Option Two: Invest $1,000,000 in a financial instrument that will grow tax deferred and be taxed at long-term capital gains (assuming 15%) rates upon realization of gains.

Option Three: Invest $1,000,000 in a financial instrument which is tax deferred and taxed as ordinary income (33%) on withdrawal (i.e. Deferred Annuity)

Option Four: Invest $1,000,000 in a financial instrument that has tax-free growth on earnings and tax-free withdrawal of basis and gains.

The above case study shows how investors are being forced to seek higher "taxable equivalent" returns to generate the spendable income they need. Thus they are exposed to greater volatility and the risk of principal loss. Clearly investing in a tax-free environment (option 4) will generate the most spendable income however there are only two financial instruments today that offer tax-free growth AND tax-free access; a Roth IRA and a correctly structured life insurance policy.

Now that we are clear on how to avoid the erosion of wealth from taxation, the question becomes "What vehicle/strategy will provide liquidity, safety of principal and rates of return?"

INDEXED UNIVERSAL LIFE:

Within an investment grade "Indexed Policy," the policy's cash value can be invested in one of two strategies (which can be changed by the policy owner at anytime). The first is a fixed return strategy in which the insurance carrier will provide a fixed, tax-free return of approximately 5% annually. This fixed return will fluctuate with overall interest rates. In any given year, the policy owner can choose to allocate some or all of his cash values away from the fixed option and into the "indexing" option. "Indexing" is a principal protection hedging strategy that allows the cash values to participate in general market gains while avoiding the downside. The insurance carrier buys options that are correlated to the S&P 500® and if the market goes up, the policy's cash values participate in the gains. However, if the market goes down, one does not participate. The catch? There is 15% "ceiling" so if the market goes up over 15% in any given year, the policyholder only participates up to 15%. But if the market is negative in any given year, there is a 0% floor. On each anniversary the gains are "locked in" and the policy's cash value is "reset" so that this becomes the new principal amount or "high-water mark" on which the subsequent year's gains will be calculated.

This "indexing" strategy has averaged 8.81% annually over the past 30 years all without the risk of principal loss. Keep in mind, because gains aren't taxed, this strategy also has the benefit of tax-free compounding. Between 2000 and 2010, during what advisors call the "lost decade", a buy and hold strategy with the S&P 500® lost over 7% when all was said and done. By using this hedging strategy over the same period, "indexing" was up over 100% which is an average of over 7.2%.

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TAX-FREE ACCESS

A properly designed investment grade policy will allow for tax-free loans from the policy's cash values. These loans are called "wash loans" in which the effective interest rate is zero and the policy loans are washed away at death. The policyholder can generally borrow up to 99% percent of the funds so long as there is always enough remaining to cover the cost of the insurance. The loan is not required to be repaid during the life of the insured and will simply be deducted from the overall death benefit when the insured passes on. Again, no tax ramifications are created in this process. Any difference between the death benefit and loan balance will be left to the beneficiaries resulting in a tax-free transfer of assets.

FINAL THOUGHTS

Many of you might read this and while you agree with the points made, there is still that nagging thought of "I thought life insurance was a poor investment." Actually, we agree with you! This is because 99% of life insurance professionals and money managers are unaware of how to structure a policy correctly to maximize the tax benefits and minimize the insurance costs. In addition, while many carriers offer the products described above, only a handful have proven to be efficiently priced over time. If you are interested in a custom proposal for you or your client, please give us a call to schedule a time to speak.