Blog #51: Avoiding the Tax Bomb in Life Insurance

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If you advise clients to purchase max-funded life insurance policies (just short of a MEC) with the intention to access those values to supplement retirement cash flow, you have four choices in how that can occur, all of which are governed by IRC Section 72:

  1. Annuitize the cash value.  This eliminates the policy death benefit.  A portion of each annuity payment is considered a return of the cost basis of the policy and is not taxable.  Once cost basis is recovered all payments are taxable.
  2. Withdraw funds from the policy.  Withdrawals in excess of cost basis are taxable.
  3. Withdrawals up to cost basis; loans thereafter.  Withdrawals are tax free.  Loans are tax free provided the policy stays in force.
  4. Loans from the policy.  Loans are tax free provided the policy stays in force.

#3 and #4 include a growing tax bomb once loans begin.  This is relatively easy to deal with initially, but over time, it can create a serious financial problem for the uninformed client if the policy is surrendered or lapsed.

Example:

Assumptions (at time of surrender or lapse at an advanced age):

  • Cumulative premiums paid are $250,000 (the cost basis).
  • Policy gross cash value is $1,000,000.
  • Policy net cash value is $100,000 (after deducting a loan balance of $900,000).
  • If the policy is surrendered or lapsed, the taxable gain is $750,000 ($1,000,000 - $250,000).  Likely all (or certainly most) of it will be taxed at 45% or more.
  • 45% of $750,000 is $337,500.
  • The net cash surrender value is $100,000 leaving your client short $237,500 of the taxes due ($337,500 - $100,000).

This is not a pretty picture.

The safest method of accessing cash from the policy is #1 (annuitize) or #2 (withdrawals).  Both result in taxable income, but the potential tax bomb (taxes due with insufficient residual cash value to pay the tax) is avoided.

#3 has typically been a good choice for all tax free cash flow (tax free withdrawals to basis followed by tax free loans).  This reduces the amount of loans which correspondingly reduces the potential tax bomb.

Participating loans (loans that continue to earn whatever interest is credited to the policy) has changed the preference for many to #4 (loans only) but increases the potential tax bomb.  The risk is reduced if there is a guaranteed loan interest rate.

With #3 or #4, the tax bomb can be avoided if the policy is neither surrendered nor allowed to lapse, since the policy death benefit wipes away the income tax liability.  The foundation of this special treatment is IRC Section 101.  This statute provides that the proceeds of life insurance maturing as a death claim are exempt from federal income tax.  This applies to the full death benefit, including any cash value component whether loans exist or not.

A lurking tax bomb can be present in all forms of whole life and universal life where policy loans are utilized.  It can be avoided, and you, the producer, are key to making sure your clients are aware of how to sidestep it.

Can your clients remember these facts years into the future?  If they are incapacitated, will family members understand the issues?  It is probably best to attach a short note to the policy -- something like this (although your compliance officer will likely have preferred language):

If/when you take policy loans on this policy, be sure to talk to your financial adviser before surrendering or lapsing the policy in order to anticipate unexpected tax consequences that may otherwise be avoided.

Does that note on the policy make it hard or easy to deliver the policy?  It’s very hard if you haven’t discussed it with your client; very easy if you have.  And that’s the point -- it should be discussed.

It is best if you design the policy illustration with no premiums due after retirement if loans are anticipated in retirement years.  An in-force policy with no premiums scheduled is much more tolerable at advanced ages than one with continuous premiums.

A small handful of life insurance companies have concierge units that monitor loan status at the point of lapse or surrender.  To be effective regarding the tax bomb, they need to be proactive in their client relationships, not merely reactive to client inquiries.  I hope that ultimately the policyholder service division of all life insurance companies will bring this potential liability to the attention of those surrendering or lapsing policies, particularly those policies with 50% or more of the gross cash value subject to outstanding loans.  I also hope that any such policies issued with lapse supported pricing do not produce “let ‘em lapse” directions from senior management.

Next week, I’ll show you a mathematical comparison between fixed and participating loans on the same indexed universal life policy.  The difference is significant.

New Features in InsMark

Our licensees are very excited about Jazz, Version 17.0 of the InsMark Illustration System.  Click here if you would like to see one of our most popular illustrations in this new format.

Click here if you would like to review the features of Jazz.

To license the InsMark Illustration System, contact Julie Nayeri at julien@insmark.com or 888-InsMark (467-6275).  Institutional inquiries should be directed to David Grant, Senior Vice President - Sales, at dag@insmark.com or 925-543-0513.

Important Note:  This information in this Blog is for educational purposes only.  In all cases, the approval of a client’s legal and tax advisers must be secured regarding the implementation or modification of any planning technique as well as the applicability and consequences of new cases, rulings, or legislation upon existing or impending plans.

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More Recent Blogs:

Blog #50: The Cost of Waiting

Blog #49: More CheckMate Selling®

Blog #48: Dollars of Benefits for Pennies of Cost

Blog #47: Tom and Kristin’s Retirement Planning

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Robert B. Ritter, Jr. Blog Archive

 

Blog #50: The Cost of Waiting

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(Presentations in this blog were created using the InsMark Illustration System.)

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To be certain of having life insurance when you need it, you should acquire it before you need it.  So an important factor to consider involves the advantage of acquiring your policy now -- while your health may be the best it ever will be.  Of even greater importance, should something unexpectedly happen to you in the short term, your family will be protected.

Here is another reason for acquiring life insurance early:  Harvey Pierce, MD, is an internal medicine physician.  He is age 45 and has determined that the participating policy loan features of an Indexed Universal Life (IUL) policy can provide him with a superb retirement supplement.  The death benefit of the policy, while certainly valuable to him and his family, is not the primary reason for his interest.

His adviser is encouraging him to purchase the policy now.  Dr. Pierce asks, “I will commit to this, but does it really make much difference if I do it now or in a couple of years?”

This question can be easily answered using the Cost of Waiting module available on the Personal Insurance tab in the InsMark Illustration System.

We’ll compare the following two alternatives:

  • $500,000 increasing death benefit IUL issued at age 45 (max-funded with 20 annual premiums of $23,717 -- just short of a MEC -- with policy loans starting at age 65).
  • $500,000 increasing death benefit IUL issued at age 47 (max-funded with 18 annual premiums of $25,384 -- just short of a MEC -- with policy loans starting at age 65).

Here are the results:

Insured: Harvey Pierce, MD
Current Age: 45
Indexed Universal Life

Plan A: Buy Now

Indexed Universal Life

Plan B: Wait Two Years to Buy

Initial Policy Death Benefit: 521,414 Initial Policy Death Benefit: 522,779
Policy Premium: 23,717 Policy Premium: 25,384
Number of Premiums to Age 100: 20 Number of Premiums to Age 100: 18
Cum. Premiums at Age 100: 474,340 Cum. Premiums at Age 100: 456,912
Cum. Loan Proceeds at Age 100: 4,068,766 Cum. Loan Proceeds at Age 100: 3,425,677
Cash Value at Age 100: 727,776 Cash Value at Age 100: 608,174
Death Benefit at Age 100: 1,227,776 Death Benefit at Age 100: 1,108,174
Cash Value Gain at Age 100 by Buying Now: $119,602
Cumulative Loan Proceeds Gain at Age 100 by Buying Now: $643,089
Death Benefit Gain at Age 100 by Buying Now: $119,602
Premiums Saved by Waiting Two Years to Buy: $17,428

In this example, Dr. Pierce would have to earn a pre-tax equivalent rate of return of 15.19% year in and year out on the difference in premiums and loan proceeds to match the results of buying now.

Click here to review the full illustration.

Dr. Pierce asks, “Does it only work out this way when you run it to age 100?  How does it look at my life expectancy -- age 85 for example?”

Here are those results:

Insured: Harvey Pierce, MD
Current Age: 45
Indexed Universal Life

Plan A: Buy Now

Indexed Universal Life

Plan B: Wait Two Years to Buy

Initial Policy Death Benefit: 521,414 Initial Policy Death Benefit: 522,779
Policy Premium: 23,717 Policy Premium: 25,384
Number of Premiums to Age 85: 20 Number of Premiums to Age 85: 18
Cum. Premiums at Age 85: 474,340 Cum. Premiums at Age 85: 456,912
Cum. Loan Proceeds at Age 85: 1,948,876 Cum. Loan Proceeds at Age 85: 1,628,362
Cash Value at Age 85: 953,993 Cash Value at Age 85: 920,175
Death Benefit at Age 85: 1,453,993 Death Benefit at Age 85: 1,420,175
Cash Value Gain at Age 85 by Buying Now: $33,818
Cumulative Loan Proceeds Gain at Age 85 by Buying Now: $320,514
Death Benefit Gain at Age 85 by Buying Now: $33,818
Premiums Saved by Waiting Two Years to Buy: $17,428

In this example, Dr. Pierce would have to earn a pre-tax equivalent rate of return of 14.06% year in and year out on the difference in premiums and loan proceeds to match the results of buying now.

Click here to review the full illustration.

Conclusion

In Dr. Pierce’s case, the Cost of Waiting analysis shows that the attractiveness of a short-term delay in funding is more than offset by a significant increase in after tax cash flow which is his primary reason for acquiring the policy in the first place.

It makes little difference whether you are presenting a very large or very small amount of insurance -- Cost of Waiting is very useful in helping clients understand that acting now has very favorable financial consequences.  It’s a point that is difficult to convey without the mathematical comparison illustrated in this Blog.

Licensing

To license the InsMark Illustration System, contact Julie Nayeri at julien@insmark.com or 888-InsMark (467-6275).  Institutional inquiries should be directed to David Grant, Senior Vice President - Sales, at dag@insmark.com or 925-543-0513.

 

InsMark’s Digital Workbook Files

If you would like some help creating customized versions of the presentations in this Blog for your clients, watch the video below on how to download and use InsMark’s Digital Workbook Files.

Digital Workbook Files For This Blog

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Note:  If you are viewing this on a cell phone or tablet, the downloaded Workbook file won’t launch in your InsMark System.  Please forward the Workbook where you can launch it on your PC where your InsMark System(s) are installed.

 

InsMark’s Referral Resources

If you would like assistance with an InsMark illustration, contact any of the Referral Resources listed below.  They are all highly skilled at running InsMark software and can help you using your choice of insurance company.  Mention my name when you talk to one of our Referral Resources as they have promised to take special care of my readers.

Joint Interviews

If you want or need help from a qualified producer for joint interviews with any InsMark illustration and are willing to share the case, email us at bob@robert-b-ritter-jr.com, and we will provide you with recommendations.

Testimonials:

I have been using InsMark since it was a C:> prompt back in the early 1980s.  The new Jazz release is the most exciting upgrade to the system I’ve seen in 28 years!  With unlimited options for customization, you can now be as creative as you want when producing illustrations.  I downloaded it last night, and used it successfully with my first appointment this morning.
Chris Jacob,  CFP, InsMark Power Producer, SFI-Cadeau,  St. Louis, MO.

"InsMark is the Picasso of the financial services world - their marketing savvy never fails to amaze me."
Doug Peete,  (Past President, Top of the Table), InsMark Power Producer,  Overland Park, KS

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Blog #48: Dollars of Benefits for Pennies of Cost

Blog #47: Tom and Kristin’s Retirement Planning

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Blog #49: More CheckMate Selling®

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(Presentations in this blog were created using the InsMark Illustration System and Life Plan System.)

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Editor’s Note:  All the InsMark illustrations available in this Blog were prepared using the Jazz release (Version 17.0) of the InsMark Illustration System.  We think you’ll like the new features.  Click here if you would like to learn more about the new features of Jazz.

Someone asked me recently if it’s possible to explain all you need to know about the powerful mathematics of cash value life insurance in a simple illustration.  We have such an illustration called Life Plan located on the Personal Insurance tab of the InsMark Illustration System.

Below are the results with the Life Plan module using an Indexed Universal Life policy insuring Harvey Pierce, MD, age 45.  It is a $500,000 policy (increasing death benefit) with premiums of $23,717 for 20 years.  Participating policy loans are illustrated starting at age 65.

blog-49-summary-of-pre-retirement-and-retirement-years-image

Click here to view the entire Life Plan illustration.

Note:  Life Plan is also available in Spanish.

Life Plan produces a lot of information in just a few pages.  While it produces a concise analysis, it ignores one of the most fundamental components of a good life insurance presentation -- it lacks a comparison.  Almost everyone makes better decisions in a comparative environment, so let’s introduce some comparisons to go with it.

We’ll select one of our most popular modules, Various Financial Alternatives (“VFA”), and compare the Indexed Universal Life to a:

  • Tax Exempt Account @ 3.00%
  • Taxable Account @ 6.00%
  • Tax Deductible Retirement Plan @ 7.50%

Below is a graphic of the results from age 45 to 95:

blog-49-Various-Financial-Alternatives-image

Click here to view the entire VFA illustration.

We are edging into what we call CheckMate Sellingsample, i.e., anticipating a prospect’s objections before they are raised.  Various Financial Alternatives certainly helps in this regard.

The only remaining issue is likely “what about term insurance?”  So let’s add a comparison to term insurance and a side fund.  We’ll take the best of the alternatives, Tax Deductible Retirement Plan @ 7.50%, and couple it with $500,000 of 20-year level term insurance with an annual premium of $600, the kind of solution that Suze Orman prefers.  I can hear her now:

“Why would you pay almost $24,000 for something you could get for $600?”

This graphic tells you why:

blog-49-term-comparison-illustration-image

Click here to view the entire term comparison illustration.

Conclusion

Indexed Universal Life is a remarkable financial instrument.  The combination of Life Plan, Various Financial Alternatives, and a Term comparison make it irresistible for a prospect with the cash flow to acquire it.

Licensing

To license the InsMark Illustration System, contact Julie Nayeri at julien@insmark.com or 888-InsMark (467-6275).  Institutional inquiries should be directed to David Grant, Senior Vice President - Sales, at dag@insmark.com or 925-543-0513.

 

InsMark’s Digital Workbook Files

If you would like some help creating customized versions of the presentations in this Blog for your clients, watch the video below on how to download and use InsMark’s Digital Workbook Files.

Digital Workbook Files For This Blog

Blog49.zip

Download all workbook files for all blogs

Note:  If you are viewing this on a cell phone or tablet, the downloaded Workbook file won’t launch in your InsMark System.  Please forward the Workbook where you can launch it on your PC where your InsMark System(s) are installed.

 

InsMark’s Referral Resources

If you would like assistance with an InsMark illustration, contact any of the Referral Resources listed below.  They are all highly skilled at running InsMark software and can help you using your choice of insurance company.  Mention my name when you talk to one of our Referral Resources as they have promised to take special care of my readers.

Joint Interviews

If you want or need help from a qualified producer for joint interviews with any InsMark illustration and are willing to share the case, email us at bob@robert-b-ritter-jr.com, and we will provide you with recommendations.

Testimonials:

I have been using InsMark since it was a C:> prompt back in the early 1980s.  The new Jazz release is the most exciting upgrade to the system I’ve seen in 28 years!  With unlimited options for customization, you can now be as creative as you want when producing illustrations.  I downloaded it last night, and used it successfully with my first appointment this morning.
Chris Jacob,  CFP, InsMark Power Producer, SFI-Cadeau,  St. Louis, MO.

"Life Plan demonstrates an illustration that simply depicts the benefits of the basic life insurance policy.  It is an ideal program for the package sale.  I still run into individuals with a basic need for life insurance and cash value accumulation vehicles who are under the level where more complex planning is needed and who are not yet in the mindset for retirement distribution planning.”
Mel Gross,  CLU, ChFC, MSFS,  Houston, TX

"InsMark’s Life Plan presentation provides a valuable tool for our agents in discussing retirement plans with their clients.  Its concise and to-the-point design makes the concept very easy to understand.  And, having it available in both Spanish and English has proven to be extremely useful."
Zerita Reynolds,  CLU, ChFC, FLMI, LLIF, REBC, RHU Director, Advanced Markets,  Aviva USA

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More Recent Blogs:

Blog #48: Dollars of Benefits for Pennies of Cost

Blog #47: Tom and Kristin’s Retirement Planning

Blog #46: Let’s Make Sure the Girls Go to College

Blog #45: Controlled Executive Bonus Plan for
Life Insurance and Disability Income
(Part 5 of “Valuing the Business”)

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(Part 4 of “Valuing the Business”)

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Robert B. Ritter, Jr. Blog Archive