The potential for attractive returns can make life insurance a powerful (even surprising) way to protect your legacy and strengthen your portfolio.
Life insurance has a bit of an image problem. Many people put off buying it, incorrectly viewing it as “an expensive product that is a poor investment,” says James D. Gothers, a director with Merrill Lynch’s Wealth Structuring Group. But that may be because they’re thinking about life insurance in its most basic form — a replacement for the income of the family’s wage earner should he or she die prematurely. That’s obviously a very important benefit, but a closer look reveals life insurance to be a more flexible product than many may realize.
“Life insurance can be used as an estate planning tool, whether it’s for wealth transfer or for liquidity to pay taxes,” says Gothers. “Life insurance has gotten more cost effective over the last 10 years as the mortality tables have been re-evaluated. People are living longer, which has made insurance less expensive.” Indeed, life insurance can be a powerful asset class in a well-diversified investment portfolio, helping you achieve long-term goals such as transferring wealth, funding retirement or paying for college.
Efficient estate planning
If your goal is transferring wealth, life insurance can potentially increase the size of the inheritance and reduce much of the tax burden on your heirs. As an example, consider a 70-year-old couple taking advantage of their annual federal gift tax exclusion ($13,000 per person, per year) by giving their two children a total of $52,000 every year. In 20 years, when the couple is 90 years of age, they will have given their children a total of roughly $1 million, all of it exempt from estate and gift taxes.
Now consider how much the same couple could have transferred by making their $52,000 annual gift to an irrevocable life insurance trust (ILIT). Let’s assume that the husband and wife make gifts of the $52,000 to the ILIT, and the ILIT uses those gifts as an insurance premium. At their ages, assuming good health, the $52,000 will purchase about $2.8 million of second-to-die life insurance. Second-to-die insurance has both individuals insured under the same contract, and the death benefit pays out when the second person passes away.
If we assume that both parents pass away at age 90 — meaning that the parents had paid the $52,000 premium for 20 years — they will have put in a total of roughly $1 million over the years, but their beneficiaries will actually receive the insurance company-guaranteed $2.8 million death benefit free of income and estate taxes. “The rate of return at age 90 is about 8.8% net of all taxes and fees,” says Gothers. One could argue that this same rate of return would be difficult to achieve in a taxable account. To help illustrate this, hypothetically it would take investing $52,000 each year for the next 20 years, with an average return of about 8.8% net of all taxes and fees, to produce roughly $2.8 million.
The products used in these scenarios are typically guaranteed universal life contracts. Provided the scheduled premiums are paid on time, the death benefits are guaranteed by the insurance company. “With those kinds of returns, you can make a solid argument for investing excess income into a life insurance contract held in trust,” Gothers says. “Having this low-risk asset means you don’t have to worry whether your current asset allocation will deliver the inheritance you want to leave. That offers you more freedom in investing your other assets.”
This approach can work for smaller estates too. “The $52,000 per year in that example is taking advantage of the annual gift exclusion, currently $13,000 per year, per person,” says Gothers. “The strategy will work for smaller amounts as well. If you have income that you are reinvesting with a goal of wealth transfer, consider leveraging the excess income into a life insurance policy.”
Whether you use an ILIT or not, purchasing life insurance as part of an inheritance should be part of a comprehensive financial strategy. Unlike many other investment vehicles, an insurance policy will lapse if you stop paying premiums — meaning you can lose what you’ve already put in. “Often couples will wait a few years after retiring before establishing an ILIT, when they know how much they are spending on their retirement lifestyle and what their excess income is each year,” says Gothers.
The funding for an ILIT might come from an IRA’s required minimum distributions, income from municipal bonds or dividend income, for instance. Potential future expenses also need to be considered before committing to paying the life insurance policy’s annual premiums. “If you don’t have long-term care insurance, for example, perhaps you fund an ILIT with $42,000 in annual premiums and spend the other $10,000 a year on long-term care coverage,” says Gothers. There are hybrid insurance products available that can provide life insurance coverage and long-term care expense protection. Some of these products can be paid for with annual premiums, and others offer a one-time lump sum payment option. There are a variety of options available, and should be carefully looked at as part of an analysis of your needs.
A new retirement income stream
Life insurance doesn’t have to benefit only your heirs. You can use a life insurance policy as a taxadvantaged investment vehicle to provide cash during retirement or for other liquidity needs, such as college tuition. “A permanent life insurance contract has all the advantages of a Roth IRA but none of the limitations,” says Gothers.
Like a Roth IRA, you invest after-tax dollars. You pay the premiums each year and have the option of investing additional premiums that grow tax-deferred and can be withdrawn or borrowed free of income tax. When funds are taken from the insurance contract’s cash value, the basis, or premiums paid, is taken first. Since premiums are paid with after-tax dollars, the funds are withdrawn tax-free.
When the basis is exhausted, additional funds may be taken via loans if there is sufficient value in the policy.* Because the event is a loan, it is not a taxable event. Also, there are no income restrictions that may make you ineligible to contribute, there are no set contribution limits, and the additional 10% income tax will not apply if you tap the funds before you’re 59½. And because any withdrawals that come out of an insurance contract’s cost basis are free of income tax, you may realize a higher rate of return than if you had held similar investments in a taxable account, according to Gothers. The time to consider this strategy is after you’ve fully funded any qualified retirement plans, such as your 401(k) plan or IRA, with pre-tax dollars.
Don’t forget the fine print
Although life insurance can be a vehicle for tax-efficient investing, it is, first and foremost, life insurance. The federal tax laws require that you maintain a death benefit in the contract to get the full tax advantages, which means you can’t withdraw the policy’s entire cash value. “You also have to keep the contract until you die, and policy fees are still taken from the cash each year, even though you may no longer be paying premiums,” says Gothers.
Fees, including the cost of insurance charges, an annual investment management fee, and a mortality and expense charge, can be 2% per year or even higher. But the flexibility of life insurance makes it a useful asset. “If you find you don’t need the money in the life insurance contract for retirement, for example, you can purchase an immediate annuity and use the income as a gift to an ILIT to purchase second-to-die insurance and use it for estate planning purposes,” says Gothers.
There are many types of life insurance available. Some products potentially build cash value. The cash value can build in a variety of ways depending on the type of insurance policy: It can build through the insurance company's general account that typically has a periodically declared fixed interest rate; it can accumulate dividends; or it could grow through underlying investment options embedded in the policy. (The policy fees and charges are taken from the premiums when paid and the cash value on a monthly basis.) With insurance policies that potentially grow value, there is risk that the cash may not grow as expected: whether it’s due to a decline in the credited interest rates from the general account, a decrease in the credited dividend or underperformance of the aforementioned underlying investment options. In these situations, there is risk that additional premiums may be required.
“Life insurance is complex, so before you use it for estate or retirement planning, discuss it with your Financial Advisor, who can make sure the features of a particular policy are right for you,” Gothers notes. “When life insurance is part of your overall long-term financial strategy, it can enhance your own financial security as well as that of your heirs.”