I explained to her that about 20 years ago, I started paying annual premiums into a whole life policy that was designed to have low loads and high cash values. Each March, right after receiving my annual bonus from work, I’d faithfully write a premium check to the insurance company. Nothing much happened with my policy during those 20 years other than the cash value account in the policy grew tax deferred.
Fast forward to last year when my family was grown, and I had transitioned from working in industry to working in academia. In other words, I didn’t need the death benefit anymore, and my taxes were lower. I made a tax-free exchange of my policy into an immediate payout annuity. Now my wife and I receive a monthly guaranteed amount that will pay us until the last of us die. And the taxes on the cash values that I experienced over the past 20 years are being prorated over our life expectancy. Keep in mind that I could have died during my pre-retirement years, and my wife would have received a substantial tax-free death benefit. But I didn’t die, and yet I made an approximate 6% after-tax internal rate of return on my premiums.
Life insurance as an investment in estate planning - To be clear, the vast majority of life insurance is purchased for risk management. The death benefit is a hedge that provides cash in the event of an unexpected death. It’s intended to pay off debt, provide a survivor income or otherwise generate liquidity for a premature death. Even in my case, I still own other life insurance policies intended to provide a death benefit.
But life insurance, largely because of its tax benefits, can also be used as an investment. And it’s not just because of the cash value associated with permanent insurance. Consider how the death benefit of a policy can generate millions in tax savings for a wealthy family. Rich families often use dynasty trusts to move their millions down through the generations. In this case, the family is the investor, not the individual. The challenge for these family dynasties are the three federal transfer taxes that charge a flat 40% rate on transfers: the gift, estate and generation skipping transfer taxes (GST). While these taxes can quickly deplete a wealthy estate, current law allows an exemption of $11.4 million before they apply. So, Generation 1 can set up a trust that uses $11.4 million to skip a generation, landing the wealth in the hands of Generation 3, transfer tax-free. Generation 2 doesn’t suffer for wealth because they live off the income in the trust. The question is what investment to use to maximize the efficiency of the $11.4 million exemption in moving money through the generations.
A popular solution in GST tax exemption planning is life insurance. This product has the advantage of paying exactly when needed, i.e. at the insured’s death, and it pays a benefit that is income tax-free. Let’s take an extreme example to demonstrate the leverage. A wealthy individual, Gen 1, uses her entire $11.4 million generation-skipping tax exemption to pay a one-time premium for life insurance. Assume the policy’s death benefit is $25 million and it resides in a dynasty trust. The trust is structured so that after Gen 1’s death, it collects the insurance proceeds income tax-free, and begins paying interest income to her children, Gen 2. The $25 million principal in the trust will eventually go to the grandchildren, Gen 3, after Gen 2’s death. Life insurance has maximized the leverage of this transaction. When Gen 1 died, the trust received $25 million income tax-free, and neither Gen 1 nor Gen 2 pay gift, estate or GST taxes on the death benefit. In the end, Gen 3 has $25 million in trust and the dynasty continues. Even accounting for inflation, the family experiences little, if any, diminution in the value of their wealth through three generations.
An added consideration is that the federal exemption is slated to return to a lower amount starting in 2026. This means that the exemption will revert to an inflation adjusted $5 million. So, the family that utilizes life insurance as an investment currently has the added advantage of leveraging the high exemption while it is available. The IRS has indicated it will not “claw back” this high exemption once it has been used. So, leveraging the exemption is a matter of “use it or lose it.”
Life insurance as an investment in retirement planning - The example I used above of my own policy is more typical of how life insurance can be used as an investment. In essence, I utilized the policy as a way to tax-efficiently supplement our monthly income. The policy first deferred taxes during my high-income earning years, and now spreads both the income and the income tax out over my lower earning years.
There are other ways to structure cash value life insurance to help supplement retirement income planning. It should be emphasized, however, that in all cases the insurance is first and foremost a means of providing a death benefit. Section 7702 of the U.S. Internal Revenue Code requires insurers to maintain a sufficient risk element in the policy to qualify the product as life insurance under the tax code. So, while the policy is in force, a death benefit is always in play.
That said, a popular life insurance retirement planning strategy involves directing as much premium as possible into cash value with the least amount allocated to the death benefit. This typically requires fiddling with two death benefit types and two premium tests – a function best handled by the insurance advisor or the insurance company. The idea is to structure ongoing premiums into the life insurance policy during one’s working years so as to stuff the product with tax deferred cash value. Then, at retirement, the policy turns into a source of income more than death benefit. Accumulation and risk protection during the working years switches to decumulation and retirement income.
Here’s how it works (using a Universal Life insurance policy as an example): first, at retirement, the owner stops paying premiums, thereby adding to cash flow. Next, working with the in-force cash values in the policy, the retiree determines an ongoing level income to take from the policy. The original source of that income is the owner’s tax basis in the contract. Life insurance has the advantage of first-in-first-out (FIFO) tax treatment, so the income coming out of the policy is initially treated as a return of premiums. Once the tax basis has been exhausted, the owner switches to making capitalized loans from the policy. In other words, the loan would be for the desired income plus the interest required for the loan itself. Since this income is a loan, no tax applies. The primary caution of this retirement income strategy is to not take out so much cash value as to have the policy lapse. If the insurance policy runs out of money, the owner incurs income tax without any corresponding cash to pay the tax.
This may all sound like a witches’ brew and more trouble than it’s worth. But some life insurance companies have become adept at making the process surprisingly easy. One noted company automates the entire income process so that the checks come monthly; the company knows when to switch from withdrawals of basis to loans, and then, when the values start to run out, the policy is essentially collapsed into a contract that won’t lapse. As far as the owner is concerned, he gets a level tax-free monthly income for several years in retirement. Conceptually, the transaction works like a Roth IRA. You use after tax dollars to accumulate a fund that pays out tax-free.
Financial professionals can, and do, argue over the merits of life insurance as an investment. Accusations occur over high loads, poor administration and unrealistic illustrations. Like any investment, the results of the transactions are highly dependent on the performance of the company that handles the contract. But it is hard to disagree with the tax advantages possible with life insurance as an investment. Simply put, it builds up cash values tax deferred and can pay them out tax free.
So, back to answering my inquisitor at the meeting. Yes, in the right situation and used correctly, life insurance can be considered an investment.
Article by Steve Parrish
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