Tax-Free Life Insurance: An Untapped Investment For the Affluent
Copyright: | (c) 2011 The New York Times Company |
Source: | New York Times Digital |
Wordcount: | 1121 |
IT'S viewed as an insider's secret for the affluent: a legal way to invest in hedge funds and other potentially lucrative assets, all without paying taxes on the gains.
But private placement life insurance, as it is known, is still unfamiliar to many wealthy people -- and trickier to design properly than even some savvy investors realize, tax lawyers and financial advisers say.
''It sounds so good -- 'I can invest tax-free and get the money' -- but it's actually very complex,'' said
Private placement life insurance is an investment wrapped inside an insurance policy. The Internal Revenue Code treats the taxation of insurance differently from that of investments, like stocks or hedge funds, and does not levy federal income tax or the 15 percent capital gains on a life insurance policy when it pays out upon the death of the holder. So by stuffing an otherwise taxable investment inside a tax-free life insurance policy, investors can reap the compounded gains of that investment and the death benefit, all tax-free.
The insurance is a form of variable life insurance whose cash value depends upon the performance of investments held in the policy. It is particularly lucrative because hedge funds, which trade frequently, otherwise often carry the 35 percent short-term capital gains tax.
There are other lucrative benefits besides the absence of income taxes.
When structured properly, the gains and the death benefit can escape estate taxes and go to your heirs tax-free when you die. If structured through an offshore entity, like a foreign trust, the gains can remain out of reach of creditors or those who might sue you.
But investors appeared to be shying away from the foreign variant, Mr. Waxman said, in part because ''you have very sophisticated estate planning lawyers in
Investors may also be able to borrow up to 90 percent of the gains from the policy without paying taxes on the loan. One exception is when the policy is structured as a modified endowment contract, or M.E.C.; then, the amount borrowed is taxed at ordinary rates, typically 35 percent, and may carry a 10 percent penalty tax.
Investors who buy an M.E.C. version do so solely to pass on the death benefit free of income and estate taxes to their heirs, not to access gains tax-free before then. The
Investors must also meet several hurdles.
They must be an ''accredited investor'' and ''qualified purchaser'' as defined by the
But tax lawyers say the most difficult hurdle concerns restrictions around the choice of the investments. The ''private placement'' part means that the investor must be willing to choose, from a list preselected by the insurer, the bonds, stocks, hedge funds or other investments in which premiums will be invested. In other words, you can't try to stuff in your separate hedge fund investment, a move that can run you afoul of the
And you can't stuff in paintings or other valuables, Mr. Waxman added. He said the policies were not good for those wanting to invest in private equity, because the latter can be difficult to convert to cash.
Though the policies require only a couple of premium payments, they are hefty. Insurers that sell them typically require at least a
But the various fees that can be owed in addition to the premiums are typically well below fees for other forms of investable insurance.
They can include a one-time sales load charge, a required annual mortality expense, the monthly cost of insurance, a state premium tax and a deferred acquisition cost. If a trust or foreign corporation is set up offshore to house the policy, there are other fees, including one paid to the trustee of the entity that owns the policy.
If the policy owns hedge funds, investors may also be required to pay the typical 20 percent cut of profits and a 2 percent management fee to the fund.
The total fees associated with an onshore policy vary, but Mr. Waxman said that, as a guideline, ''we try to make the total cost of the whole thing 100 basis points or less of the cash value'' of the policy. (One basis point is one one-hundredth of a percent, so 10 basis points would be 0.1 percent, or
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