Tax Free Income

Tax-Free Income through Life Insurance. Really?

Initially, it might not seem to make much sense, but modern cash-value life insurance can be designed to produce tax-free income in the form of loans from the life insurance company to the policy owner, while the life insurance policy itself serves as loan collateral. When the insured person dies, a portion of the policy’s death benefit is used to pay loaned amounts back to the insurance company, and the balance of the death benefit (often substantial) is paid to the policy beneficiary (e.g., a spouse, children or a trust). Conceptually, this is similar to a reverse mortgage on a home.

Indexed Universal Life Insurance (IUL).

IUL has been specially designed to be more flexible and more transparent (e.g., regarding costs) and to provide better growth of cash value than other types of cash value life insurance (e.g., “whole life”). Cash value is basically the value of the policy account that accumulates after policy costs are paid from premiums. IUL works well to build wealth (with very low risk, as explained below) because its cash value grows tax-free and its death benefit and living benefits are tax-free. (In contrast to cash-value life insurance, term life insurance provides a death benefit but does not accumulate cash value. In other words, the only way to get a benefit from term insurance is to die during the limited time period (term) of the policy.)

Premiums paid for policy benefits; immediate leverage.

A typical IUL policy is designed for a certain number of annual premium payments (e.g., over 5 or 10 years). As soon as the policy comes into force, the death benefit is payable upon death of the insured. Living benefits (e.g., for serious, chronic, terminal illness) are also usually available after a year or so. In other words, from day one, premium payments are immediately leveraged up to very large death and/or living benefits. In accordance with the goal of maximizing cash value, however, the death benefit is minimized initially to minimize costs and to maximize the amount of premiums dedicated to growth of the policy’s cash value.

IUL for income is a long game (10-15 years plus), but there is Liquidity.

For income purposes, IUL makes sense when the owner does not need or want income (i.e., policy loans) for at least about 10-15 years after the policy comes into force. Of course, the death-benefit protection and access to any living-benefits (e.g., serious, chronic, terminal illness) are virtually immediate and remain for the life of the policy. Thus, IUL immediately leverages premium payments to provide substantial, potential benefits in case of premature death and certain illnesses. Furthermore, the cash value of IUL is always liquid, that is, it is available to the policy owner if necessary.

IUL Design.

Design of an IUL policy for maximum cash-value growth and maximum income is critical to its long-term viability and its ability to provide income. Design depends on the underlying policy structure and, more importantly, on the choice of policy options. An optimally designed IUL policy minimizes initial death benefit and thereby maximizes cash-value growth. Minimizing death benefit decreases policy costs, enhancing cash-value growth and, later, available income. (To qualify for the favorable tax treatment under IRC § 7702, a policy must provide a certain minimum amount of death benefit. For this reason, term life insurance is often included in the design.) Unfortunately, many greedy or ignorant insurance agents design policies for maximum death benefit, which results in increased costs (including increased commissions to agents), reduced lifetime income, and much greater risk of policy lapse (which has bad tax consequences).

Low-Risk Cash-Value Growth is linked to one or more market indices, with a 0% Floor. Cash value in an IUL policy is generally “linked” to one or more market indices; for example, to an S&P 500 fund and/or other index funds, but there is no direct investment in the markets. The cash value of a policy account is “credited” periodically at a certain percentage rate based on the growth of the linked fund during a given period (e.g., a 1-year period). For example, if an index fund had a positive rate of return, e.g., 14%, during a 12-month period, then the cash value would be credited at a rate based on (but usu. not the same as) the rate of return, e.g., 10%. If the fund had a negative rate of return, however, for example, -15%, the cash value in the policy account would be credited at zero percent, that is, there is a “0% floor”. In other words, there is no direct market risk and the policy’s cash value never goes down solely due to a negative market index. (Cash value can go down in 0% years, however, due to continuing policy costs, which is why it is important to minimize costs, as explained below.)

Options budget. How can an insurance company credit cash value at a positive rate when the markets are up, but provide a 0% floor in a downward market? By purchasing options . Essentially, the company invests policy funds in a bond portfolio, which yields a known, relatively low, but certain yield (rate of return). The company uses the bond yield (“options budget”) to purchase options in one or several index funds. If the fund has positive return, the insurance company exercises the options and credits cash value at a corresponding positive rate. If the fund has a negative return, the company allows the options to expire without exercising them and the policy cash value is credited at zero percent.

Bond Interest Rates and Inflation Protection. A policy’s options budget increases as the interest rates paid in the insurer’s bond portfolio increase. As an options budget increases, so does the potential for upside growth of cash value. For example, in year 2022, influenced by rising inflation, corporate bond yields have increased. Inflation and bond yields (and policy cash-value crediting rates) are commonly correlated. Thus, IUL also provides a hedge against inflation.

Summary of IUL benefits. IUL offers a wide range of benefits:

• an immediately available death benefit (in case of untimely death)

• immediately available living benefit options (e.g., for chronic, serious, terminal illness)

• tax-free market-linked growth, linked to (but not invested in) one or more selected market indices

• risk-free growth of policy value via 0% “floor” (no exposure to negative market returns)

• potential protection against inflation

• tax-free lifetime income (via policy loans paid back with death-benefit proceeds)

• tax-free income protects against risk of rising tax rates

• tax-free income avoids high tax bracket for other, taxable income

• income-tax-free death benefit

• asset protection (varies by state) during life of insured

• elimination of all taxes plus asset protection, forever, when owned in a dynasty trust

Are there risks associated with IUL? Yes, there can be, but proper policy design effectively minimizes risks. The most obvious risk arises if policy costs (e.g., cost of insurance, policy administration fees, agent commissions, rider fees) outstrip cash-value growth. If market indices are down over many years (i.e., the crediting rate is 0% in those years), then policy costs could gradually erode the cash value available later for tax-free income and might even cause a policy to lapse unless the policy owner adds additional premium. Recently, some bad players in the life insurance field have designed risky policies with “crediting bonuses” to make them look more attractive to clients and thereby increase sales and agent commissions. “Crediting bonuses” multiply a policy’s crediting rate by a large factor, but at the cost of exorbitant “rider fees” (e.g., 5% of total cash value every year!). The bonus is paid only in a positive year, but the high rider fee is subtracted from cash value every single year. If 0% is credited to account cash value for several consecutive down-market years, then cash value quickly diminishes and a policy could lapse (i.e., there is not enough money in the policy account to pay annual costs without additional premiums). Of course, the risks of 0% years are typically not disclosed to unwitting clients, who find out only later, the hard way, that their policies are time bombs. In contrast, a well-designed policy is robust and is capable of enduring multiple 0% years because policy costs are low.

IUL “income” is like a reverse mortgage. IUL policy loans for income are similar in many ways to a reverse mortgage on a home. Like all loans, they are received tax-free. When reverse mortgage loans are taken, the residence serves as collateral for the loans. The home itself remains untouched and intact; the home value typically increases over time (except during a real estate crash). When the owner of the residence dies, the house can be sold to pay back the loans and the balance of the house’s sale proceeds goes into the owner’s estate (or to a family trust). Similarly, with IUL policy loans, the policy itself serves as collateral. Tax-free loans from the insurance carrier are secured by the policy’s death benefit, but the policy stays intact, providing living benefits and death benefit, if needed, while the policy’s cash value continues to earn its periodic credits. As with a reverse mortgage, the borrower need not make any principal or interest payments on the loan. When the insured dies, a portion of the death benefit pays the loans plus loan interest to the insurance company, and the balance of the death benefit goes to the policy’s beneficiaries.

Premium-financing to leverage IUL. The analogy to a home can be extended to the purchase of IUL. The more money a home buyer has available, the more house can be bought. Home buyers almost always use a home mortgage to buy a bigger, better house than they could otherwise afford. The house serves as collateral for the mortgage loan. Similarly, with IUL, bank loans can be used to pay higher premium amounts and the IUL policy serves as collateral for the loaned premium payments. In a well-designed premium-financing plan, the policy owner need not provide any personal collateral or personal guarantees, need not make interest payments, and need not undergo any financial underwriting. By using leverage to buy a bigger IUL policy with greater cash value, the owner gets greater benefits, that is, more tax-free income, more living benefits, more death benefit.

IUL, best way to build and protect wealth for you and your family? On balance, IUL is arguably the safest and most reliable way to build wealth for you and your family. Depending on circumstances, it can even outperform equity investment accounts and qualified money accounts (IRA, 401(k), 403(b)), but without the risk. IUL is substantially insulated (0% floor) against downturns of the marketplace, but it grows tax-free in positive markets. It provides immediate protection against untimely death and illness. Income taken as policy loans is tax-free. There are no RMDs as with qualified retirement plans (e.g., 401(k), 403(b)). Tax-free death benefits pass directly to beneficiaries. It can be owned in a trust for efficient management and asset protection.

Contact Shoreview Insurance to learn more about IUL and to do some calculations based on your (or your client’s) particular circumstances.

Visit Shoreview Insurance to learn more about products and services that reduce risk while building financial security and peace of mind.

Copyright © 2022 by Thomas Swenson, J.D.

Disclosure: This information is intended for educational use only. No client or potential client should assume that any information presented or made available on or through this article or linked websites may be construed as personalized planning or advice. Personalized insurance planning and advice can only be rendered after engagement of the firm for services. Please contact Shoreview Insurance for further information.

Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained herein (including attachments and links) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Eliminate Taxes Forever using an Irrevocable Life Insurance Trust

An irrevocable life insurance trust (ILIT) is simply an irrevocable trust that owns a life insurance policy. A dynasty trust, also known as a GST, legacy or perpetual trust, is a flexible irrevocable trust that a trust grantor funds using lifetime exemptions for gift & estate and GST taxes. An irrevocable life insurance dynasty trust (dynasty ILIT) can provide asset protection, wealth management and wealth accumulation for many generations, or even perpetually. A dynasty ILIT grows wealth tax-free, provides asset protection, and makes distributions to beneficiaries free of gift and estate taxes forever — a good way to protect hard-earned family wealth against punitive taxes, divorce and frivolous lawsuits.

When trust assets are invested in a life insurance policy, no income or capital gains taxes are paid on investment growth, and insurance proceeds pass income-tax free to the trust (IRC § 7702). Further, as noted above, there are no gift, estate, or GST taxes, not ever. Accordingly, trust assets continually invested in life insurance policies can grow and be distributed to beneficiaries completely free of taxes perpetually.

Irrevocable life insurance trusts (ILITs) are well-known estate planning vehicles, often used to generate sufficient funds to pay expected estate taxes. Funding an ILIT requires a grantor making a completed gift to the trust (making the trust “irrevocable”) and allocation of a corresponding portion of the grantor’s lifetime gift and estate tax exemption to the trust. A life insurance dynasty trust is an ILIT to which the grantor also allocates a portion of the lifetime GSTT (generation skipping transfer tax) exemption, thereby making the trust perpetually exempt from estate and GST taxes.

Different types of life insurance policies may be considered for a dynasty ILIT, as long as a policy meets the definition of life insurance provided in the Internal Revenue Code (IRC).

Generally, for tax-free retirement income, living benefits and death benefit, this author currently recommends a so-called Indexed Universal Life (IUL) insurance policy, specially designed to maximize cash-value growth and minimize death benefit. A well-designed, standard indexed universal life insurance (IUL) policy provides sustained, market-indexed growth and minimal risk (i.e., no exposure to market downturns).

An alternative to IUL is private placement life insurance (PPLI). PPLI is a variable policy and, therefore, may provide better investment returns (but with market risk) than conventional, non-variable domestic IUL life insurance. PPLI is protected in segregated accounts separate from the general fund of the insurance company. Foreign-based PPLI has advantages over domestic PPLI. It has lower minimum premium commitments (min. premium commitment usu. $1 million), and has lower start-up fees and carrying costs. In contrast to foreign PPLI, domestic PPLI requires a minimum premium commitment of $5 million or more, only in cash, has higher fees, and is subject to state-imposed investment restrictions.

In contrast to PPLI, domestic non-variable IUL policies mentioned above do not directly own investment assets (e.g., stock equity, mutual funds) in segregated accounts; rather, the insurer invests funds and credits the policy annually depending on performance of the insurer’s investments. A domestic non-variable IUL policy is generally less risky than PPLI because it is not exposed to negative market downturns, typically having a built-in floor of 0% regardless how badly markets perform. Depending on circumstances, therefore, domestic IUL may actually outperform PPLI.

Currently, the individual federal lifetime gift and estate tax and generation-skipping transfer tax (GSTT) exemptions are $12+ million. Although the U.S. Congress could lower the exemption amounts in the future, if a dynasty trust is already established, it will (presumably) be protected against prospective changes in the tax laws.

Dynasty trusts also protect family wealth against estate or inheritance taxes imposed by some states. For example, New York’s estate tax is 10-16 percent of estate values exceeding $10+ million. Yet, New York and all other states (except Connecticut) have no gift taxes. Thus, “gifting” of assets to a dynasty trust protects them from both federal and state estate (or inheritance) taxes, as well as providing asset protection against possible creditors of trust beneficiaries.

Lifetime Income Build Your Own Pension

Build Your Own “Pension Plan” with a Guaranteed Lifetime Annuity

At the age of 65, an individual can expect to live about 25 years in retirement (a bit longer if married).

Annuities generally provide at least several of the following benefits:

• A guaranteed income for life you can never outlive

• 100% principal protection (0% floor, i.e., your money will never go backwards due to negative returns in the stock market)

• Positive, tax-deferred gains (often pegged to one or more stock indices) are locked in every year (but no stock dividends) (in deferred annuities)

• A guaranteed return in the form of a “bonus” credited to the accumulation value, in a range of 5% to 10%, depending on the product

• Inflation protection

• Peace of mind

• Certainty of covering basic needs (or more), allowing riskier investing with greater potential upside

• Guaranteed minimum death benefit for heirs

• Long-term care and/or chronic illness benefits

Does a wealth-building wealth-preservation tool with some of the above-mentioned features interest you? It should if you want a safe, happy, secure retirement.

Retirement presents numerous financial risks:

Market Risk – As one approaches retirement age, whether that is age 50, 65 or 75, the risks associated with significant downturns in the stock market become greater and more critical. Think about the dot-com crash 2000-2002, the financial crisis 2007-08, the market “corrections” occurring now in 2022, and today’s general economic uncertainties. When one is younger and still earning money in the “accumulation” phase of retirement planning, one may be relatively confident that the markets will bounce back or crawl back over the long term (i.e., over a 10-15 year time span). When one is approaching or has already reached retirement, however, there is no time for a portfolio to recover.

Sequence of Returns Risk – Sequence of returns risk is related to market risk, but it is more insidious. A market downturn and corresponding decrease in portfolio value during initial retirement years can have a devastating effect on the durability of retirement savings. A market downturn in early retirement years, means the retiree must consume principal to pay retirement expenses. As a result, there is less principal for growth when the market finally picks up again. In contrast, upside growth in a bull market during early retirement years means portfolio gains can fund initial retirement and the portfolio can actually grow. Thus, even if the market grows an average of 10% over a 20-year retirement period, a retirement portfolio might run out of money (or not) depending on what the market was doing in the initial years.

Withdrawal Rate Risk – Years ago, when bonds were paying higher interest rates, the conventional wisdom said a retiree could safely withdraw 4% a year from a typical conservative retirement portfolio over the long run. Because safe, fixed income investments (e.g., bonds) now pay low interest, 3% might now be considered safe, but more realistically only 2% withdrawal of portfolio value can be recommended.

Inflation Risk – Official government data say inflation is currently (June 2022) about 9%, the highest in 40 years. Honest economists say the real number is closer to 15%. In any case, a conventional, conservative retirement portfolio containing fixed income vehicles can hardly keep pace with inflation.

Longevity Risk, a risk multiplier – Longevity risk is the risk of outliving your retirement income. The longer you live, the longer your retirement savings need to go to support you. Problem is, nobody (except the terminally ill and the suicidal) knows how long he/she will live. Do you spend down your retirement savings as if you will live 10 more years, or 30 more years? Furthermore, longevity risk is a risk multiplier – the longer one lives, the graver are the other risks mentioned above.

Two Types of Annuities

Basically, there are two types of annuity policies, (i) immediate, and (ii) deferred.

An immediate annuity’s primary purpose is to provide guaranteed income. Typically, a lump sum policy premium is paid, and then annuity payments begin immediately or within 12 months (although some companies allow deferral of income up to 40 years). Income is guaranteed for a fixed time period (e.g., 10 or 20 years) or for a lifetime (or a couple’s lifetime).

A deferred annuity is used primarily for saving and investing. A deferred annuity does not begin payments immediately; instead, it allows money to grow over time while avoiding exposure to market downturns. Importantly, taxation on gains is deferred until distributions are taken. A deferred annuity can be “annuitized”, that is, a lifetime income stream can be turned on, or income can be turned on and off (called “systemic withdrawal”). Although a deferred annuity can be annuitized, depending on various factors, it often makes more financial sense to exchange a deferred annuity for an immediate lifetime annuity to get higher payout rates.

As with most annuity products, withdrawals or annuity payments made before age 59-1/2 are generally subject to a 10% penalty in addition to income tax, unless one of certain exceptions apply.

Building Wealth with Fixed Index Annuities (FIAs)

A fixed index annuity (FIA) is a type of deferred annuity for building and preserving wealth. It provides pretty good growth potential, no downside risk (e.g., “0% floor”), and various features that make it an excellent tool for retirement planning.

Account growth of an FIA is tied to the performance of one or more market indices and credited periodically (e.g., annually).

With proper asset allocation using FIAs as a wealth-building tool, the pain of recent stock market crashes and corrections could have been significantly mitigated. Unfortunately, the vast majority of advisors giving stock and mutual fund advice do not use FIAs to help their clients. As a result, stock market downturns take a heavy toll, financially and mentally, on most US investors. FIAs can also offer more liquidity and higher lifetime income rates than some immediate annuity policies.

Fixed Annuities

A traditional fixed annuity account grows at a set, guaranteed rate (e.g., 3.5%) and provides certainty and security by paying a regular (e.g., monthly) distribution to the annuitant(s) for the lifetime of the annuitant(s). This type of annuity still exists and is still useful. Fixed annuity policies have various payout features and options, such as a guaranteed minimum payout to beneficiaries if the annuitant dies early.

Variable Annuities

A variable annuity is deferred annuity that is both an insurance product and a security, and Shoreview LLC is currently not qualified to sell or give advice on specific variable products. In a variable annuity policy, the account funds are invested directly in the market (typically in “insurance dedicated funds”, IDFs). As such, the policy account is subject to the ups and downs of the market. A variable policy provides potential for considerable upside growth, but with considerable downside risk. With the advent of risk-free fixed index annuities (FIAs), described above, the allure of variable annuities has faded.

As mentioned above, an annuity can also be owned inside an IRA or a qualified employee retirement plan (e.g., 401(k) and 403(b) plans) to protect account values against market downturns.

Inflation protection

Some lifetime-income annuities provide a limited degree of inflation protection through riders that increase payouts each year, for example, by 1%, 3% or even 5%. Another available approach is to schedule annual payments to be low initially and to increase gradually over time. Additionally, FIAs (as well as other annuities) can provide the financial security and peace of mind to make other portfolio investments that would otherwise be too risky closely before or during retirement. Such “portfolio optimization” using riskier, inflation-sensitive investments (e.g., commodities, real estate, stocks) can then match or outpace inflation. (Of course, some of the profits can then be used to purchase more guaranteed income annuities!) Similarly, since the periodic crediting rate of an FIA is based on the overall change of one or more market indices (e.g., S&P 500) over the crediting term (e.g., one year), and because market prices usually track inflation, the policy crediting rates will generally rise with inflation, although usually with a lag. Also, the fixed, guaranteed crediting rates in deferred annuity policies also track the prevailing bond rates. Bond/interest rates and inflation often correlate. As interest rates increase, the yields of bonds held by an annuity carrier also increase (with a lag), allowing the carrier to increase the periodic policy crediting rate. Any retirement planning should also address potential long term care needs (LTC costs are always inflating), which can quickly destroy an individual’s or couple’s retirement, as well as any legacy intended for children.

Lifetime Income

Different variations of annuities can provide guaranteed lifetime income; for example, Single Premium Immediate Annuity (SPIA), Deferred Income Annuity (DIA), some FIAs.

Taxation of Annuities

The account balance in an annuity grows tax deferred. If the annuity was funded with post-tax money, then the earnings portion of every distribution corresponding to growth is taxed as regular income when distributed, while the basis portion corresponding to paid-in premium is not taxed. If the annuity is owned inside a qualified retirement plan funded entirely with pre-tax money (e.g., 401(k) or IRA plan), then all distributions are taxed as income.

Access to Funds – Random Withdrawals

Immediate lifetime income annuities are not illiquid, as some people claim; rather, an owner of a lifetime annuity could generally request a lump sum payment from the policy. A deferred annuity policy typically allows withdrawal of up to 10% of account value annually, without “surrender” charges. Usually after seven to 10 years, withdrawal (surrender) charges no longer apply. Tax penalties may apply, however, when an individual makes a withdrawal before age 59½ (except in special cases, such as death or disability, first-time purchase of a home, or as part of a life-income option plan with fixed payouts). Taxation of withdrawals is done under LIFO (last in, first out) rules, which mean that earnings are presumed to be the last monies to enter the account. Therefore, earnings are considered to be withdrawn from the account balance first and taxed as ordinary income. After all earnings have been withdrawn, additional withdrawals are treated as basis and are not taxed. (In contrast, annuitized payments are taxed as explained above).

Buying Annuities within an IRA or 401(k) or other qualified retirement plans. Money grows tax-free in retirement saving plans, but it can still be exposed to the market. A big, sustained drop in the markets close to or during retirement could cause irreparable harm. Why not buy an annuity inside a retirement plan to protect principal (with a “0% floor”) and to guarantee income? Payments from a guaranteed lifetime income annuity can actually exceed the required minimum distributions (RMDs) otherwise paid from an IRA or a qualified plan.

If you would like to learn more about annuities and other insurance products for building and protecting wealth, contact Shoreview LLC or call 303-442-3100.

Copyright © 2022 Shoreview LLC

Disclosure: This information is intended for educational use only. No client or potential client should assume that any information presented or made available on or through this article or linked websites may be construed as personalized planning or advice. Personalized insurance planning and advice can only be rendered after engagement of the firm for services. Please contact Shoreview Insurance for further information.

Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained herein (including attachments and links) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.

What Options Are Available to Settle Bank and Credit Card Debt Fast?

If you’re having trouble paying off your credit card bills, you should consider the options available to settle bank and credit card debt fast. One option is to negotiate a debt settlement for less than the balance owed. This is often a better option than having your debt sold or sent to a debt collection agency.

Paying off the smallest balances first

When it comes to bank and credit card debt, you need to know how to pay off the smallest balances first. This method is called the “avalanche method,” and it allows you to eliminate your credit card debt faster and pay less interest overall. If you have multiple credit cards, pay off the minimum on each and put any extra money toward the smallest balance. This method also allows you to use the money toward paying down your other debts, too.

Once you’ve started paying off the lowest balances first, it’s time to move on to the next highest debt. This method gives you a psychological boost while you are tackling your biggest debts. However, it can take longer and you may pay more interest than you would otherwise.

Another method to pay off your debt fast is the debt snowball method. By paying off the smallest debt first, you will gain momentum as you pay off the next smallest balance. The next debt will be paid off as well, and this cycle will continue until all your outstanding debts have been paid off.

Using a debt management plan

If you’re struggling with credit card and bank debt, you may want to consider using a debt management plan. This service can help you negotiate with your creditors and lower your interest rates and monthly payments. It can also be very helpful if you’ve fallen behind on your payments and are facing collections.

Using a debt management plan can reduce the total monthly payments you make on your credit cards by 50%. This extra money can be put towards balancing your budget or establishing a savings account. Some programs also offer free budget evaluations to help you determine how much you can realistically afford. Once you know your income and expenses, a certified DEBT counselor like SettleBankDebt can set a realistic budget for you and contact your creditors.