Use Life Insurance to generate Income

Tax-Free Income through Life Insurance. Really?

Initially, it might not seem to make much sense, but cash value life insurance can be designed to produce tax-free income in the form of loans from the life insurance company to the policy owner, while the life insurance policy itself serves as loan collateral. When the insured person dies, a portion of the policy's death benefit is used to pay loaned amounts back to the insurance company, and the balance of the death benefit (often substantial) is paid to the policy beneficiary (e.g., a spouse, children or a trust).

Indexed Universal Life Insurance (IUL). IUL has been specially designed to be more flexible and more transparent (e.g., regarding costs) and to provide better growth of cash value than other types of cash value life insurance (e.g., "whole life"). Cash value is basically the value of the policy account that accumulates after policy costs are paid from premiums. This piece pertains mainly to IUL. IUL works well because its cash value grows tax free and its death benefit and living benefits are tax free (so long as the policy stays "in force", i.e., does not lapse).

Premiums paid for policy benefits. A typical IUL policy is designed for a certain number of annual premium payments (e.g., over 5 or 10 years). As soon as the policy comes into force, the death benefit is payable upon death of the insured. Living benefits (e.g., for serious, chronic, terminal illness) are also usually available after a year or so. Death benefit is minimized initially to minimize costs and to maximize the amount of premiums added to policy cash value.

IUL for income is a long game (10-15 years plus). For income purposes, IUL makes sense when the owner does not need or want income (i.e., loans) for at least about 10-15 years after the policy comes into force. Of course, the death-benefit protection and access to any living-benefits (e.g., serious, chronic, terminal illness) are virtually immediate and remain for the life of the policy.

IUL Design. Design of an IUL policy for maximum cash-value growth and maximum income is critical to its long-term viability and its ability to provide income. Design depends on the underlying policy structure and, more importantly, on the choice of policy options. An optimally designed IUL policy minimizes initial death benefit and thereby maximizes cash-value growth. For this purpose, term life insurance is often included in the design. Minimizing death benefit decreases policy costs, enhancing cash-value growth and, later, available income. Unfortunately, many greedy or ignorant insurance agents design policies for maximum death benefit, which results in increased costs (including increased commissions to agents), reduced lifetime income, and much greater risk of policy lapse (which has bad tax consequences).

Cash-Value Growth is linked to one or more market indices, with a 0% Floor. Cash value in an IUL policy is generally "linked" to one or more market indices; for example, through an S&P 500 fund and/or other index funds, but there is no direct investment in the markets. The cash value of a policy account is "credited" periodically at a certain percentage rate based on the growth of the linked fund during a given period (e.g., a 1-year period). For example, if an index fund had a positive rate of return, e.g., 14%, during a 12-month period, then the cash value would be credited at a rate based on the rate of return, e.g., 10%. If the fund had a negative rate of return, however, for example, -15%, the cash value in the policy account would be credited at zero percent, that is, there is a "0% floor". In other words, there is no direct market risk and the policy's cash value never goes down solely due to a negative market index. (Cash value can go down in 0% years, however, due to continuing policy costs, which is why it is important to minimize costs, as explained below.)

Options budget. How can an insurance company credit cash value at a positive rate when the markets are up, but provide a 0% floor in a downward market? By using options. Essentially, the company invests policy funds in a bond portfolio, which yields a known, relatively low, but safe rate of return. The company uses the bond yields to purchase options in one or several index funds. If the fund has positive return, the insurance company exercises the options and credits cash value at a corresponding positive rate. If the fund has a negative return, the company allows the options to expire without exercising them and the policy cash value is credited at zero percent.

Summary of IUL benefits. IUL offers a wide range of potential benefits:

• an immediately available death benefit (in case of untimely death)
• tax-free growth
• tax-free lifetime income (via policy loans paid back with death-benefit proceeds)
• income-tax-free death benefit
• asset protection (varies by state)
• elimination of all taxes, forever, when owned in a dynasty trust
• risk-free growth of policy value via 0% “floor” (no exposure to negative market returns)
• upside growth linked to (but not invested in) one or more selected market indices
• living benefit options (e.g., for chronic, serious, terminal illness)

Are there risks associated with IUL? Yes, there can be, but proper policy design effectively minimizes risks. The most obvious risk arises if policy costs (e.g., cost of insurance, policy administration fees, agent commissions, rider fees) outstrip cash-value growth. If market indices are down over many years (i.e., the crediting rate is 0% in those years), then policy costs could gradually erode the cash value available later for tax-free income and might even cause a policy to lapse. Recently, some bad players in the life insurance field have designed risky policies with "crediting bonuses" to make them look more attractive to clients and thereby increase sales and agent commissions. "Crediting bonuses" multiply a policy's crediting rate by a large factor, but at the cost of exorbitant "rider fees" (e.g., 5% of total cash value every year). The bonus is paid only in a positive year, but the high rider fee is subtracted from cash value every single year. If 0% is credited to account cash value for several consecutive down-market years, then cash value quickly diminishes and a policy could lapse (i.e., there is not enough money in the policy account to pay annual costs without additional premiums). Of course, the risks of 0% years are typically not disclosed to unwitting clients, who find out only later, the hard way, that their policies are time bombs. In contrast, a well-designed policy is robust and is capable of enduring multiple 0% years because policy costs are low.

IUL "income" is like a reverse mortgage. IUL policy loans for income are similar in many ways to a reverse mortgage on a residence. Like all loans, they are received tax-free. When reverse mortgage loans are taken, the residence serves as collateral for the loans. The residence itself remains untouched and intact. When the owner of the residence dies, the house can be sold to pay back the loans and the balance of the house's sale proceeds goes into the owner's estate (or to a family trust). Similarly, with IUL policy loans, the policy itself serves as collateral. Tax-free loans from the insurance carrier are taken against the policy's death benefit, but the policy stays intact, providing living benefits and death benefit, if needed. When the insured dies, a portion of the death benefit pays the loans and loan interest to the insurance company, and the balance of the death benefit goes to the policy's beneficiaries.

Premium-financing to leverage IUL. The analogy to a house can be extended to the purchase of IUL. The more money a home buyer has available, the more house can be bought. Home buyers almost always use a home mortgage to buy a bigger, better house than they could otherwise afford. The house serves as collateral for the mortgage loan. Similarly, with IUL, bank loans can be used to pay higher premium amounts and the IUL policy serves as collateral for the loaned premium payments. In a well-designed premium-financing plan, the policy owner need not provide any personal collateral or personal guarantees, need not make interest payments, and need not undergo any financial underwriting. By using leverage to buy a bigger IUL policy with greater cash value, the owner gets greater benefits, that is, more tax-free income, more living benefits, more death benefit.

IUL, best way to build and protect wealth for you and your family? On balance, IUL is arguably the safest and most reliable way to build wealth for you and your family. It can outperform equity investment accounts and qualified money accounts (IRA, 401(k), 403(b)). IUL is substantially insulated (0% floor) against downturns of the marketplace, but it grows tax-free in positive markets. It provides immediate protection against untimely death and illness. Income taken as policy loans is tax-free. There are no RMDs as with qualified retirement plans (e.g., 401(k), 403(b)). Tax-free death benefits pass directly to beneficiaries. It can be owned in a trust for efficient management and asset protection.

Contact me at Shoreview Insurance to learn more about IUL and to do some calculations based on your (or your client's) particular circumstances.

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Copyright ? 2020 by Thomas Swenson, J.D.

Disclosure: This information is intended for educational use only. No client or potential client should assume that any information presented or made available on or through this article or linked websites may be construed as personalized planning or advice. Personalized insurance planning and advice can only be rendered after engagement of the firm for services. Please contact Shoreview Insurance for further information.

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