It’s not just about the death benefit.
Have you heard about the remarkable savings vehicle that offers the appeal of market-linked gains without the worry of market-based losses? Your accountant certainly has, and he or she is beginning to weigh in on their many benefits, guarantees and tax advantages.
1. An indexed universal life policy account value can never lose money due to a down market. Indexed universal life insurance guarantees your account value, locking in gains from each year, called an annual reset.
a. During a year of growth, the
account value will participate in typically 100 percent or more of the underlying index gains, via linkage to the published returns of the various indices (S&P 500, NASDAQ 100, DJIA, Russell 2000, etc.).
b. During a subsequent down year, an IUL principal and accumulated gains are locked in and carried forward (annual reset) to the next contract anniversary.
c. If the markets should recover the following year, the IUL account value again participates in those gains up to a pre-determined cap (typically 12 percent to 15 percent) without having to recover from the previous year’s “correction” (losses).
Not only do mutual funds not provide this safety from market declines, but an investor can lose substantial portions of both principal and past earnings during a market downturn often requiring extreme market gains just to get back to even. Because of the absence of a potential drop in account value due to market losses, IUL qualifies as a fixed product under the licensing regulations with the Department of Insurance Commissioners of all 50 states.
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2. IUL account values grow tax-deferred like a qualified plan (IRA and 401(k)); mutual funds don’t — unless they are held within a qualified plan. Simply put, this means that your account value benefits from triple compounding: You earn interest on your principal, you earn interest on your interest and you earn interest on the money you would otherwise have paid in taxes on the interest.
Unless held in a qualified plan, mutual fund gains are annually reportable and taxable, thus denying an investor the benefits of such three-fold compounding. Although qualified plans are a better choice than non-qualified plans, they still have issues not present with an IUL. Investment choices are normally limited to mutual funds where your account value is subjected to wild volatility from exposure to market risk.
3. There are no limitations on the amount that may be contributed annually to an IUL. As of the date of this article, the IRS limits the annual contribution to an IRA to $5,000 annually if the account owner is under the age of 50 and $6,000 annually if the participant’s age is 50 or higher.
4. Policy owners may access their money from an IUL without IRS penalty regardless of age. Qualified plan withdrawals prior to age 59 1/2 are subject to a 10 percent penalty in addition to being taxed as ordinary income for the year the withdrawal is take.
Commonly, people find themselves in a situation where they need to access their savings. When this means tapping into a qualified plan, the available amount of the account value is typically reduced by 30 percent (10 percent and 20 percent withholding). Then when the tax return is filed for the year in which the withdrawal was taken, additional taxes may be due if the qualified plan owner is in a tax bracket greater than 20 percent. With indexed universal life insurance, the available account value may be accessed at any time for any reason without tax or penalty via policy loans which are not required to be repaid.
5. You control your taxes, not the fund manager. IULs grows tax-deferred, and is never taxed if taken in the form of policy loans. This allows owners to control precisely if, when and how much money will be taxable, depending upon their needs and circumstances.
Mutual fund owners are subject to the fund manager’s annual capital gains distributions whether or not they redeem any shares for additional income. Many equity (stock) mutual funds have turnover rates averaging over 80 percent annually, meaning that management sells over 80 percent of their fund’s holdings every year, replacing them with other stocks (and sometimes even buying the same stocks back after Jan. 1), often in an attempt to beat their category averages.
Because of this, mutual funds rarely provide the 20 percent long-term capital gains tax rate that many claim their owners might receive. The reportable gains that a mutual fund shareholder must pay taxes on each year is exclusively a function of how long the fund manager holds the underlying investments he or she purchases, and has almost nothing to do with how long the shareholder has owned his or her fund.
6. Mutual funds often make annual taxable distributions to fund owners, even when the value of their fund has gone down in value. Mutual funds not only require income reporting (and the resulting annual taxation) when the mutual fund is going up in value, but can also impose income taxes in a year when the fund has gone down in value.
When the markets take an extended downturn after several years of sustained growth (as they did in 2000-2002 and again in 2008), fund managers will often resort to selling appreciated stocks purchased several years earlier in order to generate gains to offset those losses. This has the effect of minimizing the fund’s published loss-in-value at year end, allowing the fund to claim that it was “only” down, say, 9 percent on the year while its peer group was down an average of perhaps 17 percent.
The unsuspecting shareholder of this fund receives his Dec. 31 statement; sees his account is down 9 percent, and assumes incorrectly that “at least” he’ll owe no taxes on his “loss” come April 15; three weeks later, he receives a Form 1099-Div from his mutual fund company showing several thousand dollars of reportable income.