Unraveling the Complex World of Permanent Life Insurance

29 Sep 2023 Unraveling the Complex World of Permanent Life Insurance

Life insurance is a financial tool most people are familiar with on a basic level. It’s common knowledge that there are term and permanent life insurance policies, with the former providing coverage for a set duration and the latter offering lifelong protection. However, diving deeper into the realm of permanent life insurance reveals a complex tapestry of options, each tailored to cater to different financial aspirations and risk appetites.

While the difference between term and permanent life insurance might be clear to many, the intricacies of fixed, indexed, and variable policies often remain enigmatic. This article aims to shed light on these nuances, providing a comprehensive understanding of each policy type and strategies to harness their potential benefits to the fullest.

How permanent life insurance works

The accumulation of cash value over time distinguishes permanent life insurance beyond its lifelong coverage.

On a periodic basis, a premium is paid for the insurance policy. A portion of the premium goes toward the insurance itself, covering the risk of death. The remainder is invested into the policy’s cash value component. Over time, this cash value can grow, providing an additional benefit for the beneficiary.

Depending on the permanent life insurance policy type, the cash value might earn a fixed interest rate, be tied to a stock or bond index, or be invested in sub-accounts that resemble mutual funds. The cash value growth is typically tax-deferred, meaning you don’t pay taxes on any earnings unless you withdraw them during your lifetime.

As the cash value grows, policyholders have the option to borrow against it, often at a low-interest rate. These loans are tax-free, but if not repaid, they can reduce the death benefit. Alternatively, a policyholder can also surrender part or all of the policy to access its cash value, though this may come with tax implications and potential surrender charges.

While the premium for a permanent life insurance policy is generally higher than that of a term policy, it remains level for life, ensuring no sudden increases as you age. Some policies may even allow for premium flexibility, where policyholders can use it to pay their premiums after a certain amount of cash value has been built.

Beyond the premium, permanent life insurance policies often come with administrative fees, management fees, and other costs. It’s essential to be aware of all fees associated with the policy, as they can impact the cash value growth.

Types of permanent life insurance

Life insurance is more than just a safety net for your beneficiaries. Each type of policy has unique features that can cater to different financial goals and risk tolerances.

Fixed life insurance

Fixed life insurance, or whole life insurance, is a permanent insurance policy that offers a guaranteed death benefit and a fixed rate of interest on the cash value. Cash held in this type of insurance policy will grow at a guaranteed rate set by the insurance company, ensuring predictable, steady growth. Some fixed life insurance policies from mutual insurers can pay dividends. Though not guaranteed, dividends can be used to purchase additional coverage, reduce premiums, or even be taken as cash.

Fixed or whole-life policies are ideal for those seeking stability and predictability coupled with lifelong protection.

Indexed life insurance

Indexed universal life insurance (IUL) is a type of permanent life insurance where the potential interest earned on the cash value is tied to a specific market index, most commonly the S&P 500. One of the primary attractions to IULs is the chance to benefit from market upswings. When the index performs well, you earn more interest; however, there’s usually a cap on the maximum interest rate. Also, many IULs guarantee a minimum interest rate, ensuring your cash value won’t decrease due to poor market performance, though fees can still reduce the cash value.

One of the distinctive features of indexed life insurance is the guarantee that, even in years when the linked index performs negatively, your cash value won’t drop below a certain level, often referred to as the “floor.” This means your accumulated tax-deferred gains remain protected.

This type of insurance also allows policyholders to strategically time their withdrawals in conjunction with favorable market movements, maximizing tax-deferred gains and overall policy performance.

In sum, IULs can be a middle ground for those who want market-linked growth without the direct risks of investing in the market.

Variable life insurance

Variable life insurance stands out as it operates more like a security than a traditional insurance policy. It offers a permanent life insurance product with separate sub-accounts composed of various instruments and investment funds, such as stocks, bonds, indexed funds, and money market funds. Variable life insurance is regulated under federal securities laws due to the inherent investment risks, making it more expensive than other life insurance products.

While there are similarities between variable life insurance investment options and a brokerage account, the investment options for a variable life insurance policy are typically more limited. It’s worth noting that policyholders can’t directly purchase individual stocks or bonds like they can in a brokerage account. Instead, they choose from a menu of sub-account options the insurance company provides.

For example, let’s say you secure a variable life insurance policy with an upfront payment of $100,000. You decide to place $50,000 of that investment in a bond-focused fund and the remaining $50,000 into an equity-focused fund. As the year unfolds, the equity fund sees a growth of 10%, while the bond fund grows by 5%. Consequently, by the year’s end, the combined value of your account stands at $107,500, with the equity fund at $55,000 and the bond fund at $52,500. This amount, however, will be adjusted for any associated fees and expenses.

Unlike other life insurance types, variable life gives policyholders the ability to decide where to invest the cash value, which can potentially lead to higher cash value growth. However, with the potential for higher rewards comes higher risk. The policy’s cash value and death benefit can fluctuate based on the performance of the chosen investments, potentially resulting in a loss of cash value. Fortunately, policyholders can move funds between sub-accounts without incurring taxes or penalties. This allows for real-time, tax-free portfolio adjustments.

Advantages common to all permanent life insurance policies

Permanent life insurance is not just about safeguarding the future financial well-being of beneficiaries; it also brings a suite of other benefits.

Tax-deferred growth

For the policyholder, premiums or the initial contribution are paid into a life insurance policy with after-tax dollars. As a result, the initial contribution (typically funded by premiums) is not subject to additional tax for the policyholder or beneficiaries.

The interest or gains within the policy accumulate on a tax-deferred basis, meaning the policyholder does not pay taxes on the growth each year it accrues. If the policyholder withdraws funds during their lifetime, any amount taken out up to the basis is typically not taxable; however, withdrawals exceeding the basis are taxable as ordinary income.

For beneficiaries, the death benefit, including the gains on the basis, is generally received income-tax-free. It’s worth noting that while the death benefit is income tax-free, it can be subject to estate tax if the insured owns the policy at the time of death (and the estate exceeds the federal estate tax exemption or any applicable state estate tax thresholds).

Tax-free switching

If a policyholder wants to transition from one insurance policy to another (perhaps with better investment options or lower fees), the 1035 exchange rule allows for this switch without immediate tax implications on accumulated gains. This strategy allows for the alignment of insurance policies with evolving financial goals and market conditions.

However, it’s important to note that the funds from the old policy must be directly transferred to the new policy to qualify for a 1035 exchange. If you were to withdraw funds from the old policy and then try to apply them to the new policy, the withdrawal would likely be taxable. Before attempting to make a 1035 exchange, consulting with a tax professional is beneficial to ensure that it’s the right move for your situation and that all conditions are met.

Annuitization

Some policies allow for annuitization, transforming your policy into an annuity and providing a steady income stream during retirement. This can be a tax-efficient way to receive payouts.

Loans

Policyholders can borrow against the cash value of their fixed life insurance, usually at competitive interest rates. This borrowed amount isn’t taxable as income, making it a tax-efficient method to access funds. Depending on the policy, interest on the loan might be covered by the policy’s own dividends or growth.

Death benefit

The death benefit of a life insurance policy refers to the sum of money paid to the beneficiaries upon the death of the insured. The way this benefit is determined can vary between policies. In some cases, the death benefit is simply the face value of the policy (e.g., $1,000,000). In others, it’s the face value plus the accumulated cash value, while for some policies, it’s the face value combined with the premiums paid.

One of the most significant advantages of life insurance is that the death benefit is generally income tax-free for beneficiaries. While the death benefit is income tax-free, it may be subject to estate tax if the insured owns the policy at the time of death. Strategic planning, like setting up an irrevocable life insurance trust (ILIT) or spousal lifetime access trust (SLAT), can help avoid or minimize potential estate taxes.

Maximizing policy benefits

Life insurance policies offer more than just security; they come packed with a range of benefits, from tax advantages to flexible financial options. However, it’s about having a policy and leveraging it effectively. Proactive strategies can help policyholders and beneficiaries maximize these benefits, ensuring they extract the most value from their investment.

Premium Financing

Some high-net-worth individuals use premium financing if the premiums for a desired life insurance policy are prohibitively high. They borrow money to pay the premiums, expecting the policy’s growth to eventually cover the loan’s cost.

Roth IRA alternative

A permanent life insurance policy can be an alternative for those who can’t contribute to a Roth IRA due to income limitations. The policy accumulates tax-free cash value and can be accessed through loans, mimicking Roth’s tax-free growth and withdrawals.

Withdrawals and loans

Most life insurance policies allow policyholders to withdraw their premiums tax-free, up to the amount paid into the policy. This can provide liquidity when needed without tax implications.

Borrowing against a policy’s cash value can also offer a quick source of funds without triggering taxes. Unlike a withdrawal, a loan doesn’t reduce the policy’s death benefit unless it remains unpaid. Some choose not to repay the loan, letting the interest accrue and paying it off with the policy’s death benefit. This strategy can be tax-efficient, but monitoring to prevent the policy from lapsing is essential.

Layering policies

Instead of a single policy, consider holding multiple policies with varying terms and benefits. This allows for flexibility in accessing funds, benefiting from diverse market exposures, and adjusting to changing financial needs. By combining fixed, variable, and indexed policies, you can ensure a mix of stable returns and potential market-uplinked growth.

Key person insurance

Businesses can buy permanent life insurance for key individuals. The business pays the premiums and is the beneficiary. If the key person dies, the business receives the death benefit. Over time, the policy’s cash value can also be a source of tax-free loans for the company.

Pension maximization

Instead of taking a reduced pension payout that offers a spousal continuation benefit, an individual could take their full pension and use a portion to pay premiums on a life insurance policy. Upon their death, their spouse would receive the life insurance payout, often at a higher value than the reduced pension benefit.

Tax-efficient transfers to beneficiaries

Life insurance proceeds are typically exempt from probate. By designating beneficiaries correctly, policyholders can ensure a quick, tax-efficient transfer of assets. Also, when life insurance is placed in an ILIT, the death benefits aren’t considered part of the estate and can be shielded from estate taxes.

Gift tax strategies

You can pay premiums on behalf of another person. Depending on the current annual gift tax exclusion amount (which is currently $17,000 per recipient as of 2023), these payments can be made without incurring gift taxes or reducing your lifetime gift and estate tax exemptions.

Gifting an entire policy can also be a strategy where the giver transfers ownership of a life insurance policy to a beneficiary or trust. This removes the policy’s value from the giver’s estate, but one must be mindful of the three-year rule, which states that if the giver dies within three years of the transfer, the policy may be pulled back into the estate.

Potential pitfalls to avoid

Over-funding

Over-funding occurs when contributions to a life insurance policy exceed government-set limits, potentially causing the policy to be classified as a Modified Endowment Contract (MEC). This is determined by a measure called the 7-pay test. In simple terms, if you pay more into the policy than what would be needed to fully fund its death benefit over seven years, the policy may be considered over-funded and thus become a MEC.

Once a policy is classified as a MEC, withdrawals (including loans) may be taxed as ordinary income rather than receiving the usual tax-free treatment. Additionally, a 10% penalty tax may apply if withdrawals are made before the age of 59 ½.

To avoid this issue, regularly monitor your contributions, especially if you make flexible premium payments. Consider setting up alerts or reminders to review your annual contributions in relation to the MEC limits. If you approach the MEC limit, consult an experienced advisor about splitting the policy or redirecting funds.

Excessive withdrawals

Withdrawing too much from the cash value of a life insurance policy can lead to policy lapse or reduced death benefits, undermining the policy’s primary purpose of providing a financial safety net for beneficiaries. If withdrawals erode the cash value to a point where there aren’t enough funds to cover policy expenses, the policy could lapse.

Permanent life insurance offers a range of options and benefits that go beyond simple protection. Whether it’s the stability and predictability of fixed life insurance, the potential for market-linked growth with indexed life insurance, or the flexibility and investment opportunities of variable life insurance, several options suit different financial goals. With advantages like tax-deferred growth, tax-free switching, annuitization options, and the ability to borrow against the cash value, policyholders can maximize the benefits of their policies. However, it’s important to be aware of potential pitfalls, such as over-funding and excessive withdrawals, that can undermine the effectiveness of the policy. If you have any questions or would like to discuss life insurance options further, please contact our office to speak with one of our expert advisors.

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