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Erin Montgomery, age 27, is a graduate of Massachusetts Institute of Technology with a major in Computer Science & Engineering. She is a Software Development Manager for a major San Francisco tech company with a current salary of $160,000 plus bonus. Thanks to California’s high state income tax, her combined state and federal marginal income tax bracket is 35.00%.
After reviewing the research provided by her financial adviser, she has decided that an indexed universal life (IUL) insurance policy provides her with an unusually good opportunity for long-range savings.
Below are the life insurance illustrations Erin reviewed in making her decision – each policy is illustrated from her age 27 to 90 (a few years past her life expectancy as a hedge).
- All of them are illustrated with a $15,000 premium for 23 years until her age 50.
- Erin’s plans to retire no later than age 50, and tax free, participating, secured1 policy loans of $50,000 a year are illustrated from age 50 to age 90 – indexed at 3.00% to provide a cost of living adjustment.
- The tax free, retirement cash flow totals $3,933,164 including the indexing.
1 Secured by the policy’s surrender value.
Below is a graphic of the recommended policy’s illustrated values:
| Image 1 |
| Illustration of Values |
Click here to review the individual reports.
Following the logic that the best decisions are made in a comparative environment, the next illustration compares Erin’s policy with two different investment options using the same $15,000 as the life insurance policy with the same after tax cash flow ($50,000 indexed at 3.00%) starting at age 50. Here are the details:
| Tax Deferred Account at 7.00%. |
| Equity Account at 7.00% Growth & 2.00% Dividend. |
| vs. |
| Indexed Universal Life at 7.00%. |
| Image 2 |
| Various Financial Alternatives |
The same amount of indexed cash flow from all three options starts at Erin’s age 50. The taxable account is depleted by age 61, and the equity account collapses by her age 68. The IUL produces its indexed cash flow to age 90 (and beyond). These results are the reason this life insurance policy is usually a preferred choice. The taxable account would have to earn 10.62% to match the IUL. The equity account would have to earn 11.70% (including the 2.00% dividend) to match the IUL. (See page 5 of the reports below for confirmation of these perecentages.)
Click here to review the detailed reports.
Cash value life insurance has three main functions:
- Tax free cash accumulation;
- Tax free cash flow using withdrawals to basis or policy loans;
- Tax free death benefit (this applies to the full death benefit including any cash value component whether loans exist or not).
Erin is not married, has no dependents, and doesn’t believe she needs the policy’s death benefit. Assuming she purchases the life insurance for its cash accumulation and tax free cash flow, what valuable use can she make of the life insurance death benefit?
Charitable Beneficiary Designation
Erin is a strong advocate for the African Wildlife Foundation and makes monthly contributions in support of its projects.
Consider the following charitable beneficiary designation for her new life insurance policy:
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Primary Beneficiary: African Wildlife Foundation2 Note: This is a revocable beneficiary designation which only Erin can revoke or change whenever she desires. |
2Erin can name any charitable organization.
It’s entirely possible – even likely – that when/if she marries, she’ll want to change the beneficiary to her spouse or, perhaps, their children (in trust).
Another alternative: Erin would like any amount of savings in the policy to go to her brother, Tom, and it’s OK for African Wildlife Foundation to receive the net death benefit of the policy (i.e., death benefit minus cash value).
To accomplish this, consider the following charitable beneficiary designation:
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Primary Beneficiary: A portion of the policy death benefit equal to the policy’s cash surrender value as of the date of death payable to Tom Montgomery, brother of the insured; the balance of the policy death benefit, if any, to the African Wildlife Foundation. Note: This is also a revocable beneficiary designation which only Erin can revoke or change whenever she desires. |
With either beneficiary example, the charity selected is a passive participant in the transaction, and any action taken on the policy by the Erin (including, but not limited to, withdrawals, loans, surrender, and beneficiary changes) does not require the charity’s consent.
There is no income tax deduction available with charitable beneficiaries like this for several reasons, the two most common of which are:
- Erin can revoke the charitable beneficiary designation at any time;
- The charity’s portion is an unequal partial interest in the policy.
Erin likes the multiple beneficiary designation. Once the policy is issued, she intends to let the Foundation know she has assigned a portion of the death benefit to them.
Never use an irrevocable beneficiary designation for a charity when you want to reserve the right to make changes in the future. At some point, Erin will likely want to change all or part of the beneficiary and does not want to count on the charity’s permission to do so which would be required if “irrevocable” is designated. Here is amended wording she might use at a future date when it is time to remove the Foundation as a beneficiary.
|
Primary Beneficiary: The entire death payment payable to my spouse, [Name]. Contingent Beneficiary: Child(ren): [Name(s)]. Alternative Contingent Beneficiary: [Name of the trust formed on behalf of the child(ren)]. |
Different life insurance companies have different language for acceptable beneficiary designations. They are typically helpful in providing language acceptable to both the insurance company and Erin.
Query
Erin has a final question, “Why is there no cash surrender value in the first two years of this policy – and only a negligible amount in the third year?”
Her adviser responds, “That design feature creates almost $900,000 more in retirement cash flow. Let me show you examples of the difference between better long-term results and better short-term results.”
Below is an after tax, retirement cash flow comparison between the suggested policy with its better long-term results vs. an alternative policy with high early cash values with better short-term results. The high early cash values produce a worse long-term outcome in retirement cash flow.
| Image 3 |
| Cumulative Retirement Cash Flow |
| Better Long-Term vs. Better Short-Term |
There is almost $900,000 in increased retirement cash flow ($3,933,164 – $3,067,868) when early cash values are negligible. That’s 128.2% more each and every year of Erin’s retirement. This is the advantage of foregoing high, early cash values.
Click here to review the two illustrations side-by-side. You can see the year-by-year difference in cash value and cash flow starting on Pages 1, 2, and 3. Graphic comparisons continue on Pages 4 through 6.
Erin asks, “Shouldn’t everyone choose a policy with the best retirement cash flow?”
“They should unless they are planning to bail out in the first few years,” replies her adviser.
“That wouldn’t make any sense for me. OK, so let’s go ahead with the policy with the best cash flow.”
Note: Most IUL policies have a free accelerated death benefit rider, which allows you to take a portion of your death benefit while you are alive if you become terminally ill. This feature alone could persuade Erin that the death benefit has personal value to her. It also means that she could use part of the death benefit while alive to help pay for a long-term care facility.
Conclusion
IUL should make sense for any Millennial who is in a position to begin serious retirement planning. The comparison logic discussed in this Blog is essential for any comprehensive analysis of the value of this outstanding financial product.
Click here for an excellent, web-based article on cash value life insurance in general (including IUL) from Kiplinger, a Washington, DC-based publisher of personal financial advice. There are a few, negative, web-based articles on IUL typically written by financial advisers who prefer a different life insurance product – like term or whole life. If you find yourself in competition with these alternate products, consider using InsMark’s Permanent vs. Term or InsMark Compare (as used for Image 3) for side-by-side comparisons.3
3Both illustration modules are in the InsMark Illustration System.
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Important Note #1: The hypothetical values associated with this Blog assume the nonguaranteed values shown continue in all years. This is not likely, and actual results may be more or less favorable. Life insurance illustrations are not valid unless accompanied by a basic illustration from the issuing life insurance company.
Important Note #2: The 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.
Important Note #3: Many of you are rightly concerned about the potential tax bomb in life insurance that can accidentally be triggered by a careless policyowner when policy loans are present and net cash values are so low that the income tax on the gain on surrender (calculated using gross cash values less basis) is more – often significantly more – than the net cash surrender value.
This lurking tax bomb can be present in all forms of whole life and universal life where policy loans of any type are utilized. It can be avoided, and you, the producer, are key to making sure your clients are aware of how to sidestep it.
A 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.
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 file a short note with 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 this note make it harder or easier to deliver the policy? It’s harder if you haven’t discussed it with your client; easier if you have. And that’s the point – you should discuss it.
Some life insurance companies have concierge units that monitor loan status at the point of lapse or surrender, and you would be well-advised to select an insurance company with this capacity. To be effective regarding the tax bomb, such carriers 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.
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Blog #175: Best Way to Evaluate Roth Conversions (Part 1 of 2)
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