Journal of Financial Planning - November 2005

"Treat paid-up life insurance in the same manner and don't go moving it off to a trust as a knee-jerk reaction to it being life insurance."

Life's Tax Advantages

by Peter Katt, CFP®, LIC

As is commonly known and often expressed in this 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 hasn't been an ownership transfer-for-value. This column highlights three situations where the tax adsvantages can benefit your clients.

Life Insurance Used for Dual Purpose of Protection and Investment

This strategy has a variety of names, and in principle has considerable merit; but for the same reason that two glasses of wine a day should not be confused with two bottles a day, prudence should be the hallmark here. Unfortunately, I have seen too many situations where clients have been pressed to convert tax-deferred assets or divert tax-deductible qualified plan contributions to life insurance premiums based on the argument that cash values are tax-deferred. This is highly inappropriate.

On the other hand, our firm has many high-earning 30- and 40-something clients who have maxed out their tax-deductible contributions and are still net savers and investors. For these clients, after we help them figure out how much family protection life insurance they need, we obtain from them the annual amount they want to save or invest medium to long term.

Let's 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 benefit of a non-modified endowment contract (MEC) for a $30,000 premium is $1 million. Tom buys $3 million of 20-year level term insurance and either a maximum-blended whole or universal life $1 million policy with premiums of $30,000 a year (blending minimizes the commissions and maximizes Tom's yield). Tom can make withdrawals up to cost basis 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 over the cost basis 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.

Life Insurance No Longer Needed

This is a common refrain from insurance agents and life settlement firms in trying to convince clients to sell their policies. And this may become a dominant idea if the estate tax is permanently repealed or compromise reform significantly lowers estate tax costs. What needs to be considered in both situations is that life insurance that is no longer needed may be wanted if policyowners have a better understanding of how flexible and valuable life insurance can be.

Sam and Ida bought a $5million 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. That 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 buying the policy, but nothing major. The current cash surrender value is $569,000.

An insurance agent obtains a life settlement offer of $725,000, which will net them $621,800 after tax. Neither Sam and Ida nor their trust needs the sale proceeds, which will simply accumulate and then be distributed to their heirs.

An alternative is to reduce the policy 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 policy's current pricing, the yield they can expect in 20 years from the death benefits, measured from the $621,800 settlement offer, is about 5.1 percent, which is income-tax-free life insurance proceeds. If they sell the policy, they can't 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 at a much lower yield.

The income tax advantage of life insurance makes it a much better asset once it has been restructured, rather 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 Alternative

Several times a year we help clients consider the use of paid-up participating whole life as an alternative to the tax-free bonds they own. These clients have tax-free bonds because their net yields are better than taxable fixed-income instruments, also taking into account the financial strength of the issuing entities. Our various calculations for clients indicate, from a historical perspective going back 20 to 30 years, that paid-up participating whole life would have provided 200 to 300 basis points better performance measured from the time of purchase until the insureds' life expectancies. The life insurance yields are a bit better if death occurs before and a bit weaker if it occurs after life expectancy. Because the life insurance company we used for this analysis has the highest financial strength ratings, our comparison was made 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 that individual bond issues are used and therefore held for a long period.

The tax-free earnings of paid-up life insurance give it a built-in advantage as its yields are closer to taxable bond returns. That said, generally the life insurance alternative protects against interest being, on average, higher in the future. Tax-free bonds protect against interest rates being lower on average. For this reason we would not recommend that all funds allocated to tax-free bonds be diverted to paid-up life insurance. Perhaps 25 to 50 percent 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 MECs, with earnings taxed first on cash withdrawals or loans. Therefore, clients should have no intention of using the funds for their own benefit. Rather, this is a class of assets that will pass on to 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 the estate. Treat paid-up life insurance in the same manner and don't go moving it off to a trust as a knee-jerk reaction to it being life insurance.

There are substantial numbers of financial advisors, CPAs, and consumer-advocate types who believe term is the only legitimate life insurance. As this column suggests, I believe their opinions are shortsighted. Clients should have access to the best life insurance planning possible and receive knowledgeable input from their advisors about this planning.

Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, Volume 18, Issue 11, November 2005.

Peter Katt, CFP, LIC, sole proprietor of Katt & Co., is a fee-only life insurance adviser located in Kalamazoo, Michigan (269.372.3497).