When the subject of income planning arises in advisor-client engagements, many advisors do not realize that cash value life insurance can play a valued role in the plan.
“Permanent life insurance is perfect for income planning purposes,” says David Anderson, a chartered financial consultant and a director of development at the Wyoming General Office of New York Life, Casper, Wyo. “This is in part because of the product’s preferential tax treatment.”
A policyowner, he adds, can borrow or withdraw against a permanent life policy up to basis (total premium payments minus outstanding loans, etc.) without incurring income or capital gains tax. What is more, values grow inside the policy tax-deferred, while death benefits come out tax-free.
Another big benefit: when policyowners retire their outstanding policy loans, sources say, they are in effect paying themselves back, recapitalizing the cash value they own.
Permanent life insurance can also be used to complement a straight life income annuity. Here, the client enjoys the maximum payout allowable on the annuity, and when income distributions discontinue at death, the life insurance policy will provide a death benefit to surviving beneficiaries.
This option may be preferable to buying a period certain immediate annuity, experts say. Such annuities guarantee a death benefit for a surviving beneficiary during the specified period, they allow, but they pay an income stream to the annuitant that is reduced in comparison to income paid out by lifetime immediate annuities.
For many clients, the income planning benefits of participating life policy issued by mutual insurance companies are particularly attractive, say sources. The reason: dividends issued to policyholders can, among other options, be used to purchase additional, paid-up insurance. These dividends–a return of premium to the policyowner–provide additional cash value against which to make withdrawals without having to resort to an interest-bearing loan. [Note: Not all life policies allow withdrawals.]
Alternatively, experts say, the dividends can be applied against policy premiums. At a certain point in the life of the contract, the accumulated dividends will pay for the policy, thus freeing up cash for retirement income.
“I will always recommend that clients surrender the dividend build-up before taking out a loan from a policy,” says Steven Spiro, a national director and past president of the Independent Insurance Agents and Brokers of New York (IIABNY) and president of Spiro Risk Management, Valley Stream, N.Y. “If clients surrender some dividends to get the cash they need, there are no tax ramifications and no interest due.”
Should clients need to borrow against a participating policy’s cash value beyond the accumulated dividends, however, then they need to be mindful of the fact that loans are treated differently from contract to contract.
Direct recognition policies, sources say, not only tack an interest charge onto the loan, but also reduce future dividends. Under direct recognition, in effect, the more one borrows the less the policy earns.
“This is why I favor participating policies that do not offer recognition dividends,” says Herbert Daroff, a certified financial planner and partner at Baystate Financial Planning, Boston, Mass. “With these contracts, you get the same dividend scale whether you borrow or not. So you have a better distribution policy because you’re not penalized for taking the money out.”
With or without dividends, observers add, policyholders also need to factor in the consequences drawing down the policy’s cash value so much as to threaten the policyholder’s continuing ability to maintain the contract. In the case of policy loans, one pitfall is that accrued interest will become cost-prohibitive to pay. Another danger is that an insured can so strip the policy of its cash value as to force the contract to lapse.
“When advisors meet with clients during their quarterly or annual reviews, they need to be running in-force illustrations to make sure the clients aren’t taking out too much,” says Anderson. “If the policy lapses, then the client would have to pay taxes on any gains.”
The danger of a policy lapse, say experts, is all the greater with variable and variable universal life contracts that fluctuate in value with the market.
Should stocks take a steep dive, an insured who has borrowed or withdrawn against the policy could be required to ratchet up premium payments significantly to keep the contract in effect. Even if the policy is maintained, if the cash value isn’t fully restored, the death benefit will be reduced by the amount of the outstanding loan or the withdrawal.
One other hazard often overlooked by policyholders, says Spiro, is a tax hit that can result when clients a surrender policy. Using a hypothetical example, Spiro noted that life policy withdrawals exceeding the contract basis will, at the time of the policy surrender, be treated as ordinary income for tax purposes. The policyholder will receive from the insurer a 1099 form to be filed with the Internal Revenue Service.
“That is phantom income because you’ve pulled out more money than you put into the policy,” says Spiro. “Most people don’t consider this to be income–but it is. And so the federal government is entitled to its pound of flesh.”
One way to keep Uncle Sam at bay, sources say, is to “maximum fund” the policy: pumping in more cash than is needed to keep the contract in force (thereby allowing more premium dollars to enjoy tax-deferred growth) but not so much as to convert the policy to a modified endowment contract (which would result in the loss of tax benefits).
Daroff frequently subscribes to this approach when recommending a “Roth look-alike” strategy: using cash value life insurance to supplement a Roth IRA or Roth 401(k) to which the client has contributed the maximum amount allowed. Or, should the client have a traditional IRA, says Daroff, the account can be converted to Roth or stretch IRA when he or she dies, the surviving spouse using the life policy’s death benefit to pay income tax on the conversion.
Permanent life insurance, adds Daroff, offers one other big benefit for income planning purposes: The vehicle serves as a “hedge” against the prospect–one that Daroff considers all too likely–that income tax rates will rise in the future.
“Precious few people know about the volatility of income tax brackets,” says Daroff. “The odds are that my high net worth clients will be in a higher than 35% tax bracket when the time comes to draw down their retirement funds.
“So it just makes sense to put away some dollars [into a cash value policy] as a hedge against the possibility of falling into a higher income tax bracket during one’s retirement years,” he says. “The funds can continue to grow tax-deferred and, at the insured’s death, be distributed income tax-free.”