Can life insurance revitalize your high-net worth clients’ retirement plans?
Tax-advantaged retirement plans such as IRAs and 401(k)s are great for middle-class employees, but low contribution limits circumscribe their value for high-net-worth executives and entrepreneurs. If the $49,000 ($50,000 for 2012) annual contribution limit for 401(k) solos and SEPs is not enough to satisfy your client’s retirement objectives, what is the next step?
Enter life insurance retirement plans (LIRPs), which offer many of the same advantages and none of the limits of their traditional counterparts. But use of life insurance as a retirement savings vehicle is controversial, so caution is warranted.
A “life insurance retirement plan” is (at least according to some critics) little more than a euphemism for “overfunded variable universal life (VUL) insurance policy.” They are typically sold to high-net-worth investors as a pseudo-Roth replacement vehicle offering long-term, tax-free accumulation of income for supplemental retirement needs. They offer the greatest benefit for investors who have already maximized other tax-advantaged retirement savings plans.
Retirement cash needs are satisfied from the LIRP via policy loans and withdrawals. Because life insurance is taxed on a first in, first out basis, tax-free withdrawals can be made up to basis. Unless the policy is classified as a modified endowment contract (MEC), loans can be taken cash free.
Contributions to the LIRP will generally need to be made for at least the first 10 years of the policy. Once the cash value of the policy catches up to deposits, loans and withdrawals may be taken.
LIRPs are typically overfunded—amounts over and above premiums are deposited into the policy—with the intention of maximizing cash value and the tax advantage of the policy.
The benefits of overfunding a life insurance policy for supplemental retirement savings are many of the same benefits touted for life insurance policies in general: (1) tax deferred accumulation; (2) asset protection; (3) the availability of disability waivers; and (4) penalty-free distributions prior to age 59½. The only limits on contributions to a LIRP are the MEC rules.
One risk inherent in the LIRP concept is the possibility that the policy will be incorrectly overfunded, resulting in the policy being classified as a MEC. Once a MEC, always a MEC; there is no fixing the mistake. If that happens, policy loans will be taxable on an income-first basis, eliminating most of the LIRP’s benefits.
Another serious risk of using an overfunded life insurance policy as a retirement savings vehicle is the possibility that the policy will lapse with outstanding loans. As with all permanent insurance that allows policy loans, if the policy lapses or is otherwise canceled while loans are outstanding, the amount of the loan will be taxed to the insured.
Be aware that LIRPs and their ilk have been called a “scam” by many in the financial advice industry. The first complaint often levied against LIRPs is the relatively high fees associated with VUL policies. If the insured does not have a need for life insurance, the cost of insurance may be an unnecessary expense that eats a significant portion of premiums. On top of the cost of insurance, other fees can quickly eat the program’s tax benefit. But a properly structured LIRP can dilute the effect of fees by aggressively overfunding the policy. The more money that is fed into the policy, the lower fees will be as a percentage of deposits. Policies that charge per deposit fees of 6 percent are obviously not good candidates for a LIRP.
Also problematic for some pre-retirees is the fact that their investment will be tied up for a period of time, unavailable for emergency purposes. Since a VUL policy is the backbone of the LIRP, it will have surrender charges for at least the first 10 years after the policy is issued.
The drawbacks of a using a LIRP as a supplemental retirement savings vehicle are less pronounced for high-net-worth families that have already maximized other tax-advantaged retirement accounts. The question for those clients is whether the fees associated with a VUL policy erase the program’s benefits. The key is that they are normally only a supplement to an otherwise robust retirement plan.
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See also The Law Professor’s blog at AdvisorFYI.