Advanced Planning With Life Insurance Products

Most people look at life insurance as a rudimentary product. And, for most people, this is perfectly fine. They need a simple, cheap term life insurance policy to cover their basic needs should they die prematurely.

However, there is a small percentage of Americans who are utilizing a life insurance contract in a much more consequential way, and this type of policy is called ordinary life insurance. Instead of only premium and death benefit components, they include a third: cash value.

This type of financial planning is a more advanced planning with life insurance as the core product focus.

These plans are definitely not for everyone, and will most likely require a very knowledgeable agent, and both a tax and financial professional, to ensure the long term benefits are properly organized, especially when used for something other than permanent death benefit.

A Little Backstory

Advanced Financial PlanningIn the Internal Revenue Code of 1954, under Section 101 (a)(1), proceeds received from life insurance, so long as they were a result of death from the insured of the contract, were established to be outside of a persons gross income. In the same document, under Section 264 (a), it was also set forth that premiums paid to keep the policy in force would not be deductible.

In other words, so long as the premiums paid were not deducted, a policy’s payout would remain tax free to the beneficiary. This is what most already know as it pertains to basic life insurance contracts, though it also pertains to ordinary life as well.

On October 25th of 1983, a bill was introduced to the senate which sought to clarify how a life insurance contract was viewed according to the Internal Revenue Code, where cash accumulation was involved, or what we call ordinary life insurance contracts. This bill, later named the Life Insurance Tax Act of 1983, would set precedent for a cash value accumulation test and test of guideline premiums which would determine the taxability of the cash accumulation portion within the contract, as well as its distributions.

In other words, so long as the cash accumulation portion was not surpassing a required threshold of premiums, it would remain to be considered a normal life insurance contract, and not a modified endowment contract.

Because life insurance was looked at almost as if it were a tax shelter, and to avoid abuse of single pay policies, Congress created what we refer to as a modified endowment contract in 1988 with the introduction of TAMRA, the Technical and Miscellaneous Revenue act of 1988.

This is important to know as the tax treatment of ordinary life insurance and modified endowment contracts (MECs) are different. Though they are different, they both play important roles in advanced planning with life insurance and we will discuss this further.

Finally, since we’re discussing the more advanced utility of ordinary life insurance, the rest of this article is written using the assumption of cash value life insurance, not term life.

How Advanced Financial Planning Using Life Insurance Works

Once you understand the major components of ordinary life insurance, you’ll know we’re speaking of products like universal life insurance, indexed universal life insurance, variable life insurance, and whole life insurance (including survivorship policies).

Each has the three required components: premiums paid, a specified death benefit, and a cash accumulation portion within them.

There are several areas of concern where these types of contracts are most suitable when it comes to financial planning:

  • Estate Planning
  • Charitable Giving
  • Business Continuation
  • Bank Owned Life Insurance (BOLI)
  • Corporate Owned Life Insurance (COLI)
  • Deferred Compensation Plans
  • more…

You’ll notice these are all long term plans. A cash value life insurance policy is almost never appropriate for short term planning, but rather compounding the benefits of the policy with time to create a tool of financial leverage. Money today can be turned into a tax advantaged stream of cash flow, or even a tax free death benefit many years down the road.

It should be noted these types of contracts are funded with after tax dollars, unlike other tools and strategies like utilizing IRA’s, 401(k)’s, 403(b)’s, or Keogh plans. However, when set up properly, both the principal and growth can retain their tax free status upon access, whereas an IRA or 401(k) is fully taxable at whatever tax rate the owner is within upon withdrawal.

The growth within the policy can come from several avenues:

  1. Premiums paid by the policy owner
  2. Interest attributed to the policy
  3. Dividends, if offered, by the issuing company
  4. Market gains, if an indexed or variable policy

A unique aspect of an ordinary life policy, when compared to traditional term policies, is the ability for the death benefit to grow, too. As the cash value grows, portions go towards additional death benefit, which not only provide extra proceeds when the insured dies, but also keeps the cash growth tax advantaged as the policy grows.

Participating Versus Non-Participating

Many carriers offer one or more types of cash value life insurance, but there are still plenty of differences between them. One of those key aspects to consider is whether or not the contract would be considered participating or non-participating.

A participating policy is one where dividends are attributed to the policy, usually which come from company profits or excess paid premium. These are most often found from mutual companies, where policyholders are the true owners of the company, as opposed to a stock company, where stockholders are.

Participating contracts are vital to understand for estate planning because of the long term benefits of growth with dividends. While most ordinary life plans have a stated interest rate, dividends, although never guaranteed, provide an added bonus on top of the existing interest. Over a long period of time, this can mean significant growth.

How Ownership Is Defined By Insurable Interest

Life Insurance Contract OwnerWhen considering long term estate planning or business continuation plans, the owner of the policy is usually different than what you might think.

With term life insurance, the most common owner and beneficiary is a family member. While this is possible with advanced planning, too, it actually often takes the form of an entity like a corporation, a named estate, or even a trust.

This is because there is something called insurable interest, which is basically any person or entity who would incur a loss or liability at the death of the insured.

For example, if a person with a considerable estate passed away, their heirs would inherit the estate, as well as the taxes the estate incurred. In this way, the deceased’s estate would be able to own life insurance with the intent to use the proceeds to offset the tax. Now, the beneficiaries who inherited the estate aren’t forced to liquidate the estate or hastily find the capital needed to pay the taxes on transfer.

Again, as stated above, advanced planning with life insurance is all about leverage. Leveraging today’s dollars for more, tax advantaged dollars in the future is the name of the game.

Accessing Cash Value

The key component marking ordinary life insurance different from term is the cash accumulation within the policy, which is accessible as long as the policy is in force. In force means still active, and not lapsed or surrendered.

Cash value is accessible in two ways:

  1. Loan
  2. Surrender

With a loan, you can access a certain amount of cash from the policy, tax free, and it is treated as a typical loan, accruing interest until it’s paid back. The loan is accounted for within the policy itself, and the principal loan amount and corresponding interest reduce the death benefit by the amount owed.

With a surrender, you can gain access to the cash value by terminating the policy altogether, but you incur the taxes due on the gains within the policy.

This is a very important distinction because, essentially, when accessed by loan in a responsible manner, cash value can grow tax free, and be accessed tax free.

One exception to this is when a policy is deemed a modified endowment contract, or MEC. Instead of FIFO (first in, first out), proceeds come out LIFO (last in, first out). In other words, the gains come out first, not the principal or premium payments. In addition, those gains are taxable, and even subject to a 10% penalty for those insured’s who have yet to reach 59 1/2 years old.

More On Modified Endowment Contract’s

While, on the surface, it doesn’t sound like MEC’s are very ideal, they do have their sweet spot. More on that in a moment.

If you don’t want to create a MEC, however, there is a rule to follow, called the 7-Pay-Test. The rule basically states you can’t pay more than a defined, cumulative amount into the policy on a rolling 7 year period. The maximum amount is defined by several factors, like the age of the insured, the amount of coverage, and the type of policy they elect.

If the 7-Pay-Test is breached, and a policy is considered a MEC, it can never revert. Once a MEC, always a MEC.

Now, for some, a MEC is still ideal. As an example, let’s compare a MEC to a single premium annuity. If a person wants to earmark a certain amount of cash for a beneficiary, and they put it into an annuity, the value becomes taxable at death to the beneficiary. With a MEC, the death benefit remains tax free to the beneficiary.

In this way, especially in a low interest rate environment, a MEC may result in a higher leveraged position than an annuity when it comes to the proceeds passed to the named beneficiary.

Common Questions About Advanced Planning

1. How do I know if I need this type of financial planning?

Though only used by a majority of Americans, there are a few situations where advanced planning using life insurance makes the most sense:

  • You want to leverage current assets, or a business, to your heirs in the future
  • You want to relieve your heirs of taxes they would incur by inheriting your estate or business
  • You want to better leverage or diversify a portion of your portfolio for tax advantaged growth

If you’re seeking a short term solution, a term policy is best for you.

2. What type(s) of advisor(s) do I need to speak with?

Typically, this type of planning will be brought to your attention by a certified financial planner, accountant, or other financial advisor who foresees you may be able to better leverage your future position.

Once you embark on this type of planning, you will likely need to consult with your financial planner, accountant, lawyer, and an independent life insurance agent, like us. In addition, they will need to work together to make sure your entire plan is built in an efficient and cohesive manner.

3. Is life insurance an alternative to my IRA/401(k)?

If anything, cash value life insurance is a supplement to a traditional IRA or 401(k) type of plan. Remember, IRA’s and similar retirement plans accept pre-tax dollars, and lower your current year’s tax bill, while life insurance premiums are paid with after-tax dollars, lowering your future year’s tax bill (ideally).

With proper planning, it should fit into your entire investment portfolio, providing a different set of benefits you can’t achieve with other retirement planning products.