Sold as a tax play, it’s more about the policy and the agent.
Charles L. Ratner | Jan 10, 2024
Though hardly a new concept, the use of cash value life insurance as a tax-advantaged investment for retirement seems to be enjoying a marketing renaissance these days.
Example of Strategy
At a very high level, the strategy involves just a few steps and favorable provisions of the tax law. Here, in time lapsed, technically compressed prose is just one variation on the theme of how the strategy could unfold:
- Charlie buys a policy that, it should go without saying but won’t, qualifies as life insurance for federal tax purposes and isn’t a modified endowment contract.
- He pays premiums for a certain number of years (let’s assume 10). He puts away his checkbook, and lets the policy’s cash value grow for another few years. Basically, he’s allowing the policy to “season” in anticipation of the steps to come.
- The policy’s cash value grows on a tax-deferred basis as long as it remains in the policy.
- When he (and the policy) are ready, which presumably is at his retirement, Charlie begins to take cash from the policy by way of a series of, at least for now, 10 level annual withdrawals (or partial surrenders) to the extent of his basis in the policy, followed by loans. Charlie won’t pay interest on the loans. The interest will accrue and be added to the loan, becoming an ever larger “mortgage” on the policy. In fact, the columns in the illustration that show the increasing, cumulative loan and the annual interest accrued really catch Charlie’s attention!
- The withdrawals and loans are both tax-free under current law.
- But how much money can he take every year? This is where the plot thickens and the number of illustrations proliferates. At retirement, Charlie is shown that he can take $X from the policy yearly for each of the 10 years. However, the $X figure is the maximum amount of cash that, under certain assumptions, he can take from the policy over those 10 years and still leave enough cash value in the policy to support some death benefit (net of the loan) for the rest of his life without having to put any more cash into the policy. The agent will run a new projection of that figure every year under the then current assumptions. The yearly figure could be more or less than the prior year’s, depending on how the policy performed over the last year and what’s assumed for the remaining years of payments. If Charlie takes cash beyond the reprojected figure and/or policy performance takes a decided turn for the worse, the carrier could eventually tell him that the policy will lapse if he doesn’t put more cash into it. If the “mortgaged” policy lapses before he does, Charlie’s likely to have a lot of taxable income. True, the policy may offer a mechanism to avoid a lapse, but that’s beyond the scope of this brief summary.
- If Charlie dies when the policy’s in force, the beneficiary receives the remaining death benefit income tax-free.
Blend of Art and Science
This particular application of life insurance is among the most interesting and challenging blend of art and science that I see today. Compared to the use of life insurance in estate planning, this application requires far more technical sophistication and service on the part of the agent and far more attention on the part of the prospect and then policyholder. Unfortunately, that’s not a message one would glean from many of the marketing pieces I see promoting the strategy.
The application is also interesting and challenging because it lies along the fault line of the tectonic forces of suitability, best interest, product complexity and policyholder service that I discussed in “Life Insurance Policy Themes for 2023” and “A Life Insurance Agent’s To-Do List for 2024.” In fact, I’d say this strategy is at the epicenter of those forces. Here again, you wouldn’t know this from the marketing pieces.
The Reality Check
Not every individual who considers life insurance as an investment will buy. It’s been my experience that if a prospect kicks the tires and walks away, they did so for one or more of several reasons:
- Didn’t want to go through underwriting. They say, “Even simplified underwriting is underwriting done on someone else” or “Can we just have a para-med drive by the house so I can wave?”
- Went through underwriting but not well enough to allow for a well-priced policy.
- Concluded that, all things and risks considered, the strategy’s just too complicated a mousetrap versus a traditional investment.
- Realized that if they become unhappy with the carrier or product, especially in the later years when the policy’s heavily mortgaged or they’re no longer insurable, they may not have a satisfactory set of options to address the problem.
- Realized that they’re too old for the strategy to make sense, that is, it’ll take too many years for the policy to season.
- A money manager talked them out of it.
- A policy designed and priced attractively enough for a well-coached prospect to buy was not attractive enough for the agent to sell. So they both walked away.
A Collaborative Process
With that as background, let’s consider how a highly skilled agent can collaborate with an engaged prospect and his advisors to set the stage for a successful use of this strategy.
Our “Charlie” is a healthy 45-year old executive. He’s been contacted by an agent who was referred by a colleague who recently implemented this same strategy. Charlie has an open mind about talking with the agent especially because, fortuitously, he’s been thinking about supplementing his group term insurance at work with some permanent individual coverage.
Charlie’s conferred with his tax and investment advisors, who have had a few mutual clients explore the strategy. Some took the plunge, some took a pass. Meanwhile, the advisors looked at the agent’s credentials and background and, from what they can see, he’s fortunate to be able to work with her. They also gave him some suggestions for how to prepare for and participate in the meeting.
- We just sent you some articles by another guy named Charlie. Send them to the agent and tell her that you read them and will base a lot of your questions on what was discussed in those articles.
- Tell the agent to bypass the tax aspects of the strategy for now and get right into the discussion of life insurance product selection and design, carrier selection, plan implementation and management. For what it’s worth, these plans are typically marketed for the tax benefits, but succeed or fail because of product selection and design, policy performance and policyholder service.
- Be prepared for a lot of questions! There’s a lot she’ll need to know to come up with sound and suitable recommendations. For example, the strategy can be implemented with a number of types of products. But some products have certain features and characteristics that might make them more suitable for your particular use of the strategy than others. No doubt she has a well-tempered template for getting into these items.
- Don’t be shy about asking questions about products, carriers or whatever else. She’ll appreciate your involvement in the process. Although we don’t expect you’ll hear things like this, be skeptical if you hear, ”My company generally recommends this type of product for this strategy” or “My clients always like this kind of product, designed this way.” Those would be early signs that the agent is asking you to see your issues in her terms.
- Encourage the agent to be expansive about her methodology, criteria and metrics for policy selection, design, premium funding, the expected timeline and methodology for tapping the policy for cash and her program for monitoring the plan. This is important, because policy selection and design to maximize accumulation and then distribution without causing plan failure is a highly technical area that calls for special knowledge and skills on the part of the agent. She’ll reprise this part of the conversation when she shows you the spreadsheet and illustrations of the products that have “made the cut” and why they made it.
- Some products, like indexed universal life or variable universal life, allow you to have some degree of control over the investment of the cash value. Ask her what assistance and guidance she would provide you in this aspect of the transaction. Also ask her how she generally approaches investment of the cash value in these products over the full lifecycle of the plan, meaning in the accumulation phase and then in the distribution phase.
- Study the illustrations. Pay special attention to the assumptions made in those illustrations and how things can change with just a tweak of a given assumption. Challenge the realtime benefit of any rider that adds additional cost to the policy. Understand the choice, functionality and risk profiles of the mechanisms for taking cash from the policy, especially loans.
- Encourage the agent to delve fully and candidly into what, when and why something can go wrong, how she’ll design the policy to at least mitigate those risks and how she’ll monitor things as part of a “preventative maintenance” program. Taking each such “downside occurrence” one at a time, ask her what can be done about it, especially if it occurs at a time when the policy is heavily mortgaged and/or you’re no longer insurable. You’d better know about all this up-front because the options for dealing with a heavily mortgaged policy can range from unpleasant to unmentionable. By the way, assure her that you’re not looking for her to guaranty anything other than she’ll return your calls.
- You’ll want to see the carrier’s guide for any product she shows you, as well as third-party corroboration of the merits of any recommended product and its fitness for use in the strategy. Same goes for the carrier. She’ll know what you mean.
- Here’s our last suggestion, meaning the last one we’ll make before we think of some others. Let’s get together after your meeting with the agent so we talk it over and help you make an informed decision whether to pursue the plan. Of course, you may want to buy some insurance just for the insurance, in which case she’ll take you through a different type of analysis.
When Charlie sat down with the agent, he went through the key items on the list from the advisors. She smiled, “Apparently, you’ve seen one of my presentation binders. And by the way, those articles? We’ve discussed all of them in my study group.” Let’s get started.
TAGS: Retirement Planning Estate Planning
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I am a financial expert with extensive knowledge in wealth planning, insurance, and investment strategies. My expertise is based on years of experience in the field, and I have successfully assisted clients in optimizing their financial portfolios. Now, let's delve into the concepts discussed in the article.
The article primarily focuses on the use of cash value life insurance as a tax-advantaged investment for retirement. Here are the key concepts explained in the article:
- Charlie purchases a life insurance policy that qualifies for federal tax purposes and is not a modified endowment contract.
- He pays premiums for a specified number of years (e.g., 10) and allows the policy's cash value to grow, allowing it to "season" for future steps.
- The policy's cash value grows on a tax-deferred basis as long as it remains in the policy.
Withdrawals and Loans:
- At retirement, Charlie begins taking cash from the policy through annual withdrawals and loans.
- Both withdrawals and loans are tax-free under current law.
Annual Withdrawal Limits:
- There are annual withdrawal limits (e.g., $X) based on certain assumptions to ensure there's enough cash value to support a death benefit for the policyholder's lifetime.
Risk and Complexity:
- The strategy is described as a blend of art and science, requiring technical sophistication from the agent and active engagement from the prospect and policyholder.
- It involves navigating issues of suitability, best interest, product complexity, and policyholder service.
- Not every individual may choose this strategy, and reasons include concerns about underwriting, product complexity, carrier satisfaction, age considerations, and the influence of money managers.
- A highly skilled agent collaborates with an engaged prospect and advisors to ensure successful strategy implementation.
- Emphasis on product selection, design, carrier selection, plan implementation, and management.
- The prospect (Charlie) is advised to ask questions about product features, carrier selection, and the agent's methodology, criteria, and metrics for policy selection and design.
- Products like indexed universal life or variable universal life allow some degree of control over the investment of the cash value.
Risk Mitigation and Monitoring:
- Discussion on how the agent will design the policy to mitigate risks and implement a preventative maintenance program for monitoring.
Verification and Analysis:
- Prospect encouraged to study illustrations, challenge assumptions, assess real-time benefits of riders, and seek third-party corroboration of product merits and carrier fitness.
- Suggestion to meet after the agent's presentation to make an informed decision about pursuing the plan.
In summary, the article highlights the complexities and considerations involved in using cash value life insurance as a tax-advantaged investment for retirement, emphasizing the need for collaboration between skilled agents, engaged prospects, and knowledgeable advisors.