If there ever was a topic that has the financial industry fighting like the Hatfields and McCoys, it is the use of life insurance as an investment.
[Sign up for stock news with our Invested newsletter.]
Financial advisors argue that life insurance is too expensive and clients can do better with other choices, like stocks and bonds. Insurance professionals will rebut those claims with information about the unique benefits and tax advantages available. All of this rancor happens even before they get into the realm of clients paying fees or commissions.
Both parties are right. And often, both parties can be wrong. There are 10 questions that you need to weigh before investing with life insurance:
— What are the different kinds of life insurance?
— Do I need life insurance?
— What is my tax bracket?
— What employee benefits are available to me?
— What do I want retirement to look like for me?
— What other savings and investment vehicles am I using?
— What is the right kind of insurance to accumulate cash?
— How do I access the cash?
— What should I be wary about?
— Are there any other considerations?
What Are the Different Kinds of Life Insurance?
You can buy either term insurance or permanent insurance.
— Term insurance is the easiest to understand. You will make a payment that is calculated uniquely for your age, gender, medical history, credit score, hobbies, travel and even driving record. When you die, the person(s) you named as the beneficiary will receive the death benefit. You are only paying for the death benefit, so this insurance is very inexpensive when you are young because your statistical chance of dying in that year is low. However, the cost rises over time and can become prohibitively expensive. It is common for insurance companies to bundle the number of years to create a smoother payment schedule, such as a five-, 10-, 15-, 20- or even 30-year term where the cost remains the same for the stated number of years, then rises to the cost for your future age.
— Permanent insurance is more complicated simply because there is an additional benefit during the holder’s lifetime — the cash value of the policy. With a policy that has a cash value, you may choose to use the cash during your lifetime for retirement income and other long-term monetary goals. You will make a payment that not only covers your death benefit, but also an extra amount to cover the accumulation of cash to meet a future goal, such as a stream of income at retirement age. This extra amount is invested by the insurance company based upon your advisor’s instructions.
Permanent insurance plans are now available in a dizzying array of investment options. For example, a variable life insurance policy may offer as many as 150 investment options for your advisor to recommend based upon your risk tolerance. Plus, many policies include living benefits that can provide cash for long-term care or a terminal illness diagnosis. Ideally, you are working with both a financial advisor and insurance professional to coordinate all your investments and insurance coverages because you can mix and match based upon your unique needs and investment goals.
Do I Need Life Insurance?
If you have zero need for life insurance to care for loved ones after your death, then a permanent policy may not be appropriate for you. This is because life insurance is first and foremost designed to pay a death benefit and there may be better investment alternatives out there.
What Is My Tax Bracket?
If you are not in a high tax bracket, it is better to be looking at life insurance purely as a death benefit. In this case, it would be prudent to purchase term insurance in a high enough amount for immediate needs, such as replacing lost income and paying off debts. Additionally, term insurance can enable the surviving parent to return to work or pay for any education necessary to be workforce ready again, as well as to be able to pay for childcare services.
It is paramount that you are purchasing the right amount of insurance before you consider the type of policy.
If you are in a higher tax bracket, it is likely that you have greater disposable income available for savings and investment. Permanent insurance can provide some important tax benefits that will be expanded upon further in this article.
What Employee Benefits Are Available to Me?
If you work for a large company, you are likely to have access to a wide range of benefits, including both qualified plans, such as a 401(k), and life insurance benefits. Smaller businesses may also provide a more limited set of options.
Typically, most companies will offer a life insurance benefit either as a flat amount (such as $50,000) or a multiple of your salary (e.g., two times your annual pay). This coverage is very inexpensive and can be an excellent way to help achieve the right amount of life insurance for you and your family’s needs. Keep in mind that this coverage is contingent on your continued employment and will end when you leave the company for any reason.
If you are an executive or considered a key person at your company, you may have the opportunity to participate in a permanent policy paid for or in conjunction with the company. Typically, companies will implement these types of permanent policies for business purposes, so it is important to understand who owns the policy and who is the beneficiary of the plan. These arrangements can be very beneficial to both a company and their executives when implemented properly.
If you have access to qualified plans, it is prudent to participate in them before investing with a life insurance policy. This is especially true if the company matches the contribution you make. If the company does not match the entire contribution and you are in a higher tax bracket, your financial advisor can help you determine how much to allocate to qualified plans, since there are restrictions on accessing the funds before retirement.
What Do I Want Retirement to Look Like?
In retirement, you are going to be replacing your professional income with an income stream generated from your investments. Therefore, it is important to understand how you envision living in retirement.
For example, if you are adhering to the financially independent retire early (FIRE) movement philosophy, you will need to be investing in assets that can be readily converted to income at a younger age. This may limit your contributions in qualified plans due to the strict requirements necessary to avoid penalties and excess taxation.
Life insurance cash values are not a short-term investment. As long as you have a minimum of 15 years of accumulation, the policy has been designed properly and someone is actively monitoring distributions, it can be a viable source of income and a means to bridge early retirement with qualified funds and social benefits, such as Social Security payments.
What Other Savings and Investment Vehicles Am I Using?
Diversification may seem like an old-fashioned concept, but it can be invaluable for creating income stream options that are flexible and legally minimize taxes. This is important because tax laws are constantly changing.
Permanent life insurance is another asset class that can provide both. However, just as you would not want to invest everything in only one stock, you do not want to overweight your portfolio with cash value life insurance.
What Is the Right Kind of Insurance to Accumulate Cash?
As noted above, permanent insurance comes in multiple flavors depending on how the cash values are expected to grow. There is not a perfect life insurance policy. However, it is critical that the policy is designed properly to build cash effectively.
There are four design features that you should seek:
— Flexibility.
— Low internal costs.
— A death benefit that is minimized as much as established government and regulatory guidelines allow to still be classified as life insurance.
— Favorable accessibility options.
Flexibility is important because your economic situation can change dramatically. Therefore you will want a policy where the planned premium or the death benefit can be lowered if necessary if you cannot afford to make the scheduled premium payments. The most flexible policies are known as variable or indexed universal life policies.
Internal costs vary by both the kind of policy as well as the insurance company offering the product. It is not uncommon for policy costs to be higher in the early years, but drop significantly after 10 or more years. While the front-loaded charges are higher than a financial advisor’s fees in the early years, they are often significantly lower in the distribution phase, when you want fees and taxes to be as low as possible.
Variable and indexed policies are considered unbundled policies because it is possible to see exactly how much the internal costs are year by year. The insurance carrier can include this report in the lengthy illustration that is required for you to review and sign.
The most important design feature is that the death benefit is minimized as much as possible so that the excess premium is going into investment growth versus paying for the death benefit. The insurance industry is restricted to a very specific set of guidelines so that the policy receives the unique and favorable tax benefits of life insurance. However, you are only paying for the net amount at risk instead of the full death benefit. The net amount at risk is the death benefit minus the cash value. Your agent will design the policy to make this number as small as possible, another way that the internal costs remain low.
[READ: 7 of the Best Tax-Free Municipal Bond Funds]
How Do I Access the Cash?
Favorable accessibility options are a key feature that makes life insurance unique from other investment choices.
When a policy is optimized for retirement income, your income stream will come from two sources:
— Principal: Equal to the total premiums paid.
— Policy gain: The amount the policy has earned above the premiums paid.
Due to the favorable treatment that the IRS gives to life insurance, you can create a tax-free stream of income by first making principal withdrawals. Once the principal has been exhausted, you will shift from withdrawals to policy loans.
Seth Wasserman is the founder of Three Points Insurance Design LLC in Hartford, Connecticut, and specializes in designing life insurance products for financial advisors and advanced insurance professionals across the country. He does not sell insurance or make financial recommendations, but solely focuses on creating the most efficient policy design before the sale and helping advisors actively monitor the policy after it is in place. Wasserman favors two key features: wash policy loans and overloan protection riders.
He explains that a wash loan effectively neutralizes the drag from the policy loan costs. This is because, after a contractual number of years, the insurance carrier will make a credit to the policy very close to the cost of the policy loan, effectively “washing out” the loan costs.
The overloan protection rider (OLP) is especially key because it will ensure that the policy remains in force until your death. This is critical to avoid phantom taxes on the policy gain. Once the last income distribution is taken, the OLP is kick-started and will ensure that your policy does not accidentally lapse.
What Should I Be Wary About?
Without a doubt, permanent life insurance policies must be reviewed annually. They cannot be purchased and then left in a drawer if you want to maximize the cash value properly.
If you are in poor health, have hazardous hobbies or travel to dangerous destinations, you may not qualify for the lowest internal costs. Even smoking may raise costs significantly. Since keeping internal costs low is critical, you may be better served with purchasing life insurance purely for the death benefit. However, an experienced insurance professional often has the ability to present a client’s situation favorably with specialty carriers that may enable you to participate.
Wasserman speaks of the 3 D’s for a life insurance investment:
— Design. As noted above, the policy must be properly designed in order to minimize the internal costs.
— Discipline. You must understand that permanent insurance is a long-term investment. If your goals are not at least 15 years in the future, the policy will not have enough time to maximize the cash value through tax-favorable accessibility options. Your insurance professional must also exercise the discipline to consistently monitor the policy.
— Dedication. You must also be able to make the scheduled premiums on time and as agreed. Because life insurance is about maintaining the delicate balance of providing a death benefit and accumulating cash, it likes consistency. While the right policy has flexibility, your policy will not perform if you are constantly changing the premiums or abruptly stop without making additional adjustments. Fortunately, policies can be designed to accept large deposits such as an annual bonus, or a limited premium period, such as five years. However, once your plan is established, stay with it.
Unfortunately, not all insurance agents are true students of their profession and understand these 3 D’s. Many financial advisors have encountered these individuals and come away from the experience rightfully frustrated. Insurance professionals have also experienced the same frustrations in reverse.
This is why it is imperative that you are working concurrently with a well vetted financial advisor and an insurance professional. Each will serve as a check and balance, while adding their respective expertise to your situation.
Are There Any Other Considerations?
Permanent insurance used for this purpose should also not be dismissed out of hand because life insurance has unique benefits that other investments and investment wrappers cannot offer. Policies can vary on the details, so please read the illustration, prospectus and customer materials carefully. Here are some details to consider:
— The entire death benefit is immediately available when it is placed in force.
— The death benefit passes contractually to your named beneficiaries income-tax free.
— The cash value grows tax deferred, and the income stream, when properly designed, can be tax-free under current IRS codes.
— The cash value can be creditor-protected in some states.
— The policy may offer long-term care benefits or advance payments if you receive a terminal medical diagnosis.
— Life insurance cash values do not count against student financial aid, government aid and other income-based calculations.
— Life insurance policy loans are not dependent on your credit score.
— Life insurance can be assigned for loans instead of having to place other higher-earning assets with the bank.
— The stream of income may be adjusted to fit your needs in retirement. For example, you may choose to take income to fill the gap before qualified plan funds are available, then turn it off until you have spent down other assets.
— If you no longer want the policy, a life settlement company may be able to offer substantially more cash than the remaining cash value of the policy.
— If you are concerned about outliving your retirement assets, life insurance cash values can be exchanged tax-free for an annuity that will create a guaranteed stream of income for as long as you live.
More from U.S. News
How to Become a Millionaire by Investing
7 of the Best High-Yield Bond Funds
Collateralized Loan Obligations: 5 ETFs to Consider
Using Life Insurance as an Asset Class for Investing originally appeared on usnews.com
