Life Insurance After ATRA
In our
Focusing on the accumulation side, we noted that the already well-supported case for cash value life insurance (CVLI) as a tax-favored investment vehicle for high income individuals could be even further buttressed by the higher tax rates that those individuals would now be dealing with on their investment income. We’d now like to return to that topic and focus more closely on some of the key income tax and policy selection and design issues that planners should be familiar with when their clients are considering using life insurance as a tax-advantaged investment, particularly for retirement. Importantly, we’re isolating this use of insurance solely to facilitate discussion of a technically complex topic. In real time, most clients will have an array of insurance needs, and the true art and science of this aspect of practice is, arguably, how to get one policy to serve more than one need.
Key Concepts
Planners have to understand the income tax concepts associated with two distinct phases of the use of a policy for investment, that is, accumulation, meaning the growth of the cash value while in the policy, and distribution, meaning the withdrawal of cash value from the policy for income.
Though we’ll delve further into both the technical and design aspects of the associated concepts, here’s a quick preview:
• Cash value grows on a tax-deferred basis if the policy qualifies as life insurance for federal tax purposes, even if the policy is a modified endowment contract (MEC).
• Cash value can be accessed on a tax-free basis through properly structured withdrawals, partial surrenders and loans if the policy isn’t a MEC. Withdrawals and loans from a MEC are generally taxable to the extent of gain in the policy and generally will be subject to a 10 percent excise tax, if the taxpayer is under
age 59½.
• A death benefit is income tax-free, even if the policy is a MEC, absent a transfer of the policy for value during the insured’s life.
The Accumulation Phase
The significant benefit of tax-deferred growth of the cash value is only available if the policy qualifies as life insurance in the first place. If a policy meets the definition of “life insurance” under Internal Revenue Code Section 7702(a), taxation of the “inside buildup” of cash value (the annual increases in the cash value) is deferred until the owner actually receives the cash value by surrender, withdrawal (in excess of basis) or some other means. Qualification isn’t just important when the policy is issued. The policy has to remain qualified. If the policy doesn’t qualify under IRC Section 7702(a) or ceases to qualify after issue, then the cash value increases become taxable income to the policyholder.1 Therefore, it’s important to be sure the policy meets the definitional requirements of Section 7702(a) at issue at all times during its existence. It can also be wise to seek indemnification from the carrier in case a large policy fails to qualify.
Testing, testing: CVAT vs. GPT. The policy can meet the requirements of Section 7702(a) by satisfying one of two tests: (1) the cash value accumulation test (CVAT), or (2) the guideline premium and cash value corridor test (GPT). The carrier’s illustration will always indicate which test is being used, especially with a heavily funded policy.
The choice of CVAT or GPT is made in the initial policy illustration, but there’s a lot more to this choice than meets the eye. For one thing, the choice is irrevocable once the policy is issued. For another, in some cases, one test will lend itself more favorably to the way the individual intends to use the policy and the flexibility he wants for funding the policy and making adjustments to premiums or death benefit in later years. Therefore, the agent should help the client make some assumptions on those points and then show illustrations depicting the individual’s game plan under each test. In some cases, there will be no meaningful distinction between the two tests. In other cases, the distinctions will be very meaningful, even critical, to success with the policy for its intended use.
MECs: First understand, then avoid. As noted above, the unfavorable tax characteristics of a MEC in the distribution phase are good reasons for the prospective buyer to avoid buying a MEC or having a policy become a MEC in later years. However, he needs to understand the basic construct (and constraints) of a MEC to help the agent design the policy for its intended use and funding pattern. From an administrative standpoint, the carrier will indicate in its illustration whether the proposed policy will be a MEC at issuance or will become one in the future. The carrier can also be expected to monitor premium payments made during the first seven policy years and reject any that would convert a non-MEC into a MEC. In some cases, increases in benefits under the policy or other policy changes will require retesting and the start of a new 7-year period. In all cases, however, once a policy meets the definition of a MEC, it will always be one (as will any policy for which it’s exchanged).
With the MEC rules in mind, the investment-oriented buyer will want to focus on two things in the design of the policy. First, he’ll probably want to get the premiums into the policy sooner rather than later to accelerate cash value growth. Second, he’ll want to have the lowest amount of insurance permissible under Section 7702 to qualify the policy as life insurance for income tax purposes but not as a MEC. The latter design element is typically referred to as a “minimum non-MEC policy.” It can reduce the policy’s frictional costs while ensuring favorable income tax treatment for withdrawals and loans.
Therefore, based on: (1) how much premium the insured anticipates paying and for how long, and (2) when the insured anticipates taking cash from the policy, the agent can work with the carriers to render an initial set of minimum non-MEC illustrations. In many cases, the individual will see that he’ll have to spread his premiums out a few more years to achieve the desired result. He may also see that a truly minimum, non-MEC design may limit his ability to put more premium into the policy than he currently anticipates, so a higher death benefit may be appropriate.
The Distribution Phase
The individual who buys a policy as a retirement planning vehicle will presumably, one day, decide to access the cash value for income. There are two primary ways to tap the cash value: policy loans and withdrawals (from universal life (UL) or variable universal life (VUL) policies) or partial surrenders of additions (from participating, dividend-paying policies). If properly done (and the policy isn’t a MEC), either approach can allow tax-free access to the cash value. If improperly done, the policyholder could be in for a nasty surprise.
Policy loans. If a policy meets the applicable definition of “life insurance” and isn’t a MEC, a loan taken from the policy won’t be included in the policyholder’s taxable income (even if the amount of the loan exceeds the investment in the contract).2
A policy loan can be made with respect to any CVLI policy. A policy loan isn’t a withdrawal from the policy; it’s a non-recourse loan from the insurance company, secured solely by the cash value of the policy. Interest at rates stated in the policy will accrue and be added to the loan, unless paid in cash. Interest at a lower rate will be credited to the cash value for its investment in the loan, meaning that only the spread between the rates will reduce cash values.
If a loan is outstanding when a policy is surrendered or is allowed to lapse, the borrowed amount is treated as a part of the surrender proceeds or is the amount received in a lapse and becomes taxable income to the extent the total of the cash value and loan proceeds exceed the policyholder’s investment in the contract.3
Policy withdrawals and partial surrenders. In addition to borrowing against their policies, owners of UL policies can also make withdrawals from their policy accumulation accounts. Owners of participating policies can make a partial surrender of paid-up additions. A withdrawal or a partial surrender isn’t a loan; it simply reduces the value of the accumulation account, reducing the amount on which interest is credited, but the policyholder incurs no interest obligation. For tax purposes, withdrawals are treated generally in the same manner as loans, because IRC Section 72(e) applies to “any amount received” under an annuity, endowment or life insurance contract that isn’t received as an annuity, except that withdrawals become taxable to the extent they exceed the owner’s basis in the policy (while, as noted above, loans, even in excess of basis, aren’t taxable, absent a later transfer of the policy subject to the loan).
One notable exception is the forced-out gain provision that applies to certain withdrawals from UL policies. Under Section 7702(f)(7), distributions made from a UL policy resulting from a decrease in policy benefits during the first 15 years from the date of issue will be treated as income to the policyholder to the extent the cash surrender value (CSV) of the policy immediately before the distribution exceeds the investment in the policy. This surplus could occur, for example, when a reduction in the death proceeds requires a distribution from the policy (or vice versa), for the policy to continue to meet the guideline premium test under Section 7702.
Policy surrenders or lapses. If a policy is surrendered or matures (other than by reason of the insured’s death), any amounts received by the policyholder are taxable to the extent they exceed the investment in the contract, which is a basis-like concept, under Section 72(e). For these purposes, Section 72(e)(6) provides that investment in the contract is the aggregate of premiums, less dividends received in cash, used to reduce premiums or to buy term insurance. Any portion of the amount received on surrender or lapse that’s taxable is generally thought to be taxable as ordinary income, rather than capital gains because, although the policy is a capital asset, there’s no sale or exchange to support capital gains treatment; this is true even in the case of a VUL policy for which the segregated asset account is invested in equity mutual funds. Note however, that individuals should consult with their tax advisors on whether IRC Section 1234A provides capital treatment for gain on a lapse or even a surrender, even in the absence of a sale or exchange.
Applying the Concepts
Against the backdrop of the rules for taxation of withdrawals and loans, there are some basic principles and best practices to follow as part of ongoing policy management. Generally, a policyholder will access cash value first by withdrawals to basis and then by loans. But there are often exceptions, especially if the policyholder is going to tap the cash value early on and withdrawals would cause a surrender charge or result in a forced out gain. In any case, the agent should illustrate early on the long-term effect of the loan(s) on the policy, especially if the loan won’t be serviced (that is, the policyholder won’t pay the loan interest). And, once the policyholder starts taking loans, the agent should monitor the policy to tell him when and to what extent he might have to reduce the loan (or service it) to keep the policy in force. There are riders that can prevent lapse from excessive loans, but the bottom line is: Don’t let the policy lapse before the insured does.
Policy Selection and Design
With the tax concepts established, we’ll now offer a suggested process for the planning team to help the client make an informed decision about which type of product to buy, how to design it and how to fund it. But first, we’ll point out the obvious. Many clients already own policies that they might have purchased to serve more traditional needs. Some of these policies can be retrofitted and repurposed for investment. Some can’t. It all depends on the type, features and construct of the policy. For example, a traditional version of a guaranteed UL policy probably isn’t transformable to a cash accumulator. But, other types of UL, either general or separate account, and many whole life (WL)-term blend products can indeed be retrofitted. So, for example, the client will indicate how much more he’d like to pay into the policy and for how long. He’ll also indicate when he’d like to start taking income from the policy and for how many years he’d like to plan on taking it. Then, the agent can run an illustration that shows the new premium pattern, a reduction in the death benefit to the minimum that will retain the policy’s favorable tax characteristics and the maximum amount of cash that the client can take from the policy on an annual basis without having to put in more money to support the policy beyond life expectancy. Of course, many clients won’t have a re-deployable policy (or any policy at all), so they’ll have to start fresh.4
What we’re offering here is one process. It’s not the only process. We’re simply suggesting that there be some intuitive, logical modus operandi in which the client can be an active participant. If there’s no such system, it will be very difficult to keep the client focused and move him up the learning curve so that he can make informed decisions about products and carriers. Such a process can also effectively prevent the dreaded paralysis by analysis that so often derails discussions of this type, which involve concepts and terminology unfamiliar to an individual who doesn’t work in the area on a regular basis. Such a system can also facilitate communication among members of the planning team.
While the steps involved in such a process will no doubt differ from one planning team and client to another, any such process is likely to have at least some of these intended outcomes:
• First and foremost, get the client to become fully invested in the project. On a very basic level, he needs to understand that it isn’t like getting quotes for term insurance off the Internet. He’s about to ask one or more agents to do a lot of work. They’re entitled to know that he’s serious. But, the nature of the client’s investment is more profound than that, so we suspect that experienced insurance professionals would agree that the sooner the client can be put in a position in which he knows enough to make an informed decision, the better. Otherwise, the planning team will be spinning its wheels.
• A number of those decision points can be reached well before anyone gets down to the specifics of policy selection and design. For example, the client doesn’t need to know much about WL to know he’s wholly opposed to taking a physical. Or, after listening carefully about the mechanics and tax implications of getting money out of a policy or how the draconian implications of policy lapse and the real-life issues presented by an IRC Section 1035 exchange at older ages make it a lot easier to get into a policy than out of it, he may punt on the idea. Perhaps, once he sees some illustrations, he’ll realize that regardless of how attractive the concept may be, the number of years needed for the policy to build enough value to generate an attractive income stream will bump up too closely to his life expectancy.
• Get the client to understand that without at least informal underwriting, any quotes/illustrations he receives are utter guesses. We’re not suggesting that the underwriting be rushed (or pushed) in any way, shape or form, but theoretical discussions (and illustrations that assume a given underwriting classification) can only go so far beyond some education on the fundamentals. The point is that the client is here in the first place for investment. So, he and some advisors will absolutely compare the economics/internal rate of returns of this approach to investing with whatever the client could do in a taxable vehicle, and the costs of insurance will have a significant bearing on the outcome of that contest.
• Prepare the client to give the agent the most realistic set of specifications and parameters for the investment in the policy that he can. The agent is entitled to this information so that he doesn’t have to waste his time and destroy a forest with illustrations.
Product Selection
Virtually any client who sits down with an agent today is likely to be shown one or more of these types of products as an investment-oriented vehicle:
• WL/term blend;
• Current assumption universal life (CAUL);
• Equity indexed universal life (EIUL);
• VUL; and
• Private placement variable universal life (PPVUL), assuming the client has the income and net worth required for this type of product.
This menu of product choices should be more than adequate for most prospective buyers, meaning that if the buyer walks away from the purchase, it’s probably not because he couldn’t find a type of product he liked (assuming he was shown the marketplace through a wide angle lens). It’s far more likely that he walked away for one or more of the reasons noted above.
What he’s actually shown will often depend on what the agent is comfortable showing him, which in turn, will often be a function of the agent’s experience, risk tolerance, business model, carrier or producer group/brokerage affiliation and other factors. The agent’s view of what the client should see may not comport with the other advisors’ views, in which case the advisors may suggest that the client bring in another agent to give the client a fuller view of the marketplace. On the other hand, if the advisors are arbitrarily limiting what the client can see, then maybe the agent should have his own suggestions to make to the client. In any case, we want to be clear that, in our view, one type of policy isn’t inherently better than another. However, the features and benefits of one type of policy can absolutely make it more appropriate than another for a given individual.
This part of the learning curve can be pretty steep for clients who aren’t students of this business, which is the case with most clients. It can also be pretty frustrating and confusing for the client if he’s caught in the crossfire among agents (and advisors) who revere or revile certain types of products. So, the team has to figure out how to push (or pull) the client up the curve and not off it and get him to the point where he can identify the characteristics of a policy that are most important to him. Those characteristics could include, respectively, premium flexibility, investment flexibility and maybe some level of guarantees, though he may find that guarantees could be counterproductive if they limit his premium or investment flexibility.5
And, now we digress… Some of those on the planning team, even some agents, might have little or no experience with an investment-oriented insurance buyer. They will find that the mindset of this type of buyer is very different from that of the usual buyer who’s focused on replacing income or providing estate liquidity. So, those new to this milieu will have to be prepared for a very different (and often sharper) set of questions from this client than they’re used to from others.
The investment-oriented buyer will see only three columns in a life insurance policy illustration: premiums, cash values and death benefit. Almost invariably, he’ll look at those three columns and ask:
• “Let’s start with the premiums. Why does it take so long to get my money into the policy? What if I change my mind about how much I want to put into the policy, either more or less? How much more can I put into the policy without an exam?” Then he looks at the cash value column and asks a series of questions:
• “Why is the first year cash value so much less than the premium I put in and what can you do about it? Can I see all the costs and charges? Tell me again why I should wait so long to take money out of the policy. Why can’t I take more money out of the policy when I do start?” And, of course, “Can you run this at 6.75 percent versus 7 percent?” When he gets to the death benefit column, he asks:
• “Why is there so much death benefit? Why isn’t it lower? I don’t want all that insurance drag on my money! What can we do about that?” Finally, he looks up from the illustration and asks the agent:
• “This is complicated stuff. I’m going to need help to manage it. What will you do for me after I buy the policy?”
There are answers to all these questions, both technical and structural. Some of the responses are rooted in the tax laws or in actuarial science underlying the product construct. But, other responses will totally depend on the breadth of the agent’s product offering and his economics as a business person.
The exit point from this segment of the discussion is that those new to this scenario and to this type of buyer will find that the greatest single difference between this buyer and the traditional buyer is the way they look at and define risk. The traditional buyer typically defines risk in terms of the chance that his planned premium won’t be adequate to support the death benefit to the targeted age. Indeed, he’s been conditioned to define risk that way by the insurance and advisory communities, respectively. The investment buyer defines risk by reference to how long it will take him to be able to get all of his money back out of the policy. In other words, for the investor type, the safest policy is the one that has the highest real early CSV.
Setting the parameters for policy comparison. Harkening back to the product menu, the team should by now have helped the client determine what type or types of product he’d like to explore further. So, purely for example, the client might indicate that he’s most comfortable with a general account product that offers utmost premium flexibility, such as CAUL. Or, he might like the premium flexibility and investment proposition offered by EIUL. Or, maybe he likes the premium and investment flexibility of a separate account product, such as VUL or PPVUL. Or, he might want to diversify between a WL/term blend to participate in the underlying portfolio and a VUL. It’s his money and his call. Interestingly enough, it’s been our experience that clients seem to know early on which characteristics of a policy appeal to them and which don’t.
We’ll stay with our theme that the intended use of the policy is indeed “accumulation/distribution,” meaning that the client will put a lot of money into the policy, let the cash value grow for several years and then tap the policy for income. So, the mission will be to illustrate competing products under a scenario in which the client will pay a premium of $X a year for Y years and then take the maximum amount of income the policy can generate for Z years without requiring further premium to prevent the policy from lapsing before age 100, give or take. All the competing products will be illustrated under the most consistent assumptions possible, both for current and downside projections. At the end of the day, or at least at the end of a long meeting, the client will see that there are some products that, under consistently applied assumptions, project more retirement income for the Z years than the rest of those illustrated while supporting themselves for the duration with no further premiums. Now, this realization is by no means the end of the discussion. Nobody is going to walk the product with the best illustration over to the winner’s circle, throw a wreath around its neck and take a lot of photos. We still have a long way to go!
The client will be very interested to learn what causes the winners to prevail on an illustrative basis. And, the agent should be able to show him, perhaps starting with the pages in the illustration that break out the details for charges and credits to the policy on an annual basis. Then the “whys” turn to “what ifs” and, pretty quickly, the client has the best grasp yet of how the products work and why, at least on an illustrative basis, some look better and more efficient than others. Then it’s time for the rest of the story, a discussion that transcends the numbers and gets into the comparative features of the products now under consideration and, of course, the respective carriers’ financial strength, overall histories for supporting their products and existing policyholders and their histories with that particular type of product and other items. At the end of the day, the client will make the decision based on well supported recommendations of the agent.
—Portions of this article were presented at a workshop given by the authors and
—The views expressed herein are those of the authors and do not necessarily reflect the views of
Endnotes
1. See Internal Revenue Code Section 7702(g)(1)(A).
2. See IRC Section 72(e)(5).
3. See Barr v. Commissioner, T.C. Memo. 2009-250.
4.
5. In his practice,
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