Permanent life insurance, particularly cash value life insurance, is a contentious topic in financial planning. Many advisors sell it for the wrong reasons, often to clients who don’t truly need it. In our experience, the most suitable candidates for permanent life insurance are high net worth families, typically with over $5 million in assets.
Before considering permanent life insurance, it’s crucial to maximize tax-advantaged retirement accounts, such as 401(k)s, pensions, and 529 plans for education expenses. High net worth families often have these bases covered.
Permanent life insurance can be valuable for three main reasons:
It’s essential to work with an advisor who doesn’t oversell these policies, as overfunding a policy can lead to tax consequences. Overall, the decision to use permanent life insurance should align with your specific financial goals and circumstances. If you have questions about this strategy in your financial plan, please don’t hesitate to reach out for personalized advice.
Permanent life insurance is a very controversial topic in the financial planning industry. Mainly because what we have found, especially coming from a large insurance company broker dealer, is that a lot of advisors sell cash value life insurance for the wrong reasons, for selling it to families and people that don’t necessarily fit the mold of a household that really should utilize that in their financial planning.
So what we’re going to talk about and what we have found the most useful situations for permanent life insurance is with high net worth families. High net worth families being north of $5 million in net worth and anything up and beyond that, 5100 million dollars in net worth.
These situations we found the most useful and beneficial, mainly because they’ve already done all of the other planning in place. So we want to make sure before we ever have a conversation around cash value life insurance, we are maxing out any tax favored retirement accounts.
So 401, cash balance, pension plans, anything that’s set up through an employer or if you’re a self employed business owner, we’re maximizing all of that for tax benefits. The second would be 529 plans for any education planning.
All the growth in that is tax free if used for education. Third would be backdoor. Roth IRAs or health savings account. We want to make sure all of those are utilized and maxed out first. And generally when we’re talking with high net worth families, those are all done, those boxes are checked.
And so now assets are beginning to accumulate in a non qualified brokerage account. Anything in there, the growth is tax at either interest or dividends, are taxable at marginal tax rates, which for high net worth families, that’s 37%.
Which is the highest marginal tax rate currently. And any long term capital gains are taxed at highest capital gains rate of 23.8%. So we’re going to talk about and look at scenarios of using cash value life insurance for three main reasons.
We’re going to throw out the death benefit to most of these families. In situations, clients are self insured, meaning they’re never going to spend all of their assets. Large nest egg of retirement accounts, brokerage is going to get passed on to children anyway.
So three main benefits of utilizing whole life insurance as an asset is, number one, for tax efficiency, number two, for asset protection and number three, for safety. So the first main benefit is for tax efficiency.
So like I mentioned, high net worth families, you already have all your retirement accounts maxed out. Cash is starting to accumulate, number one, either in cash and bank accounts. Or two, the only other option you have is saving into a non qualified brokerage account.
Any growth on that is going to be taxable. So if you are invested in anything that’s kicking off interest or dividends, you’re paying the highest capital gains rate with whole life insurance. All of the growth is tax free accumulation.
So eventually you do pay taxes on that if you pull it out. But if you put in use an example of a million dollars into the policy and the cash accumulation 20 years down the road is $2 million. You don’t pay any taxes along the way like you would on if you were invested a million dollars into a bond portfolio each year.
That interest that’s kicked off, you’re going to pay taxes on. So the first main benefit is the tax free accumulation. If you draw on the policy, you can always pull out that million that you put in tax free and then any other growth would be taxed at your marginal tax rate, which would be the exact same as whether you’ve invested in an equivalent of.
Of bonds anyway. So comparing the cash value accumulation to bonds or fixed income, if we look. At corporate bonds, they’re going to get a higher rate of return than municipal bonds. But corporate bonds, you’re subject to federal taxes if held inside of a brokerage account.
So you’re going to hit with the highest marginal tax rate. You’re paying taxes every single year on the interest or dividends. So one of the most tax efficient. Things you can do is hold corporate. Bonds inside of a taxable investment account.
Municipal bonds, on the other hand, would accumulate tax free. There’s no federal income tax, but that. You’Re going to sacrifice a lot of. That growth to do that. So right now, given low interest rates right now, the last couple of years.
We’Ve seen historically low interest rates. Bonds are kicking out one to 2% in interest. And even if you’re not paying any taxes, that’s not a very high rate of return. So cash value life insurance is going.
To kick off long term. We can look for an internal growth. Rate of between 4% to 5% and all of that’s going to accumulate tax. Free versus paying taxes every year in a bond portfolio. So when compared to other safe assets, this is the most tax efficient vehicle that we could save into.
Second main benefit is asset protection. So especially with high net worth individuals. And families, generally when you’ve accumulated a. Lot of money and you’re successful, people will look for any way possible to sue you or look for some way to take some of that money.
So anything in a retirement account, 529 plan, IRA, 401K, cash balance plan, that’s all asset protected. And this is state dependent, but most states those are asset protected. Meaning if you got into a lawsuit.
And they sued you, they would never. Be able to access any of money in those accounts. On the other hand, cash in a. Bank account is not asset protected. Depending on the state and how the account is titled.
Sometimes joint investment accounts can be asset protected, but we’ll operate under the assumption that they are not money. Cash that accumulates in a cash value life insurance policy is asset protected in most states.
Again, state specific, we’d want to look at your state specifically, but if you got sued and $2 million accumulates in that policy, the nobody could ever access that versus if that $2 million was in a taxable investment account or in cash in your bank account that could be subject in a lawsuit.
And then the third reason is for safety. So again, like I mentioned, other safe assets would be bonds holding cash, which we know is not going to get you any growth. This sheet is showing the first example is an equity portfolio worth $2 million.
It’s invested in the S and P 500 and every single year the client is going to pull out $140,000 to live on for living expenses and lifestyle. It’s going to invest in the S and P 500, pulling out 140,000 per year.
In this example of the SP, from 1998 until 2017, the S and P was down four years, 20 00 20 01 20 02 and 2008. So in this scenario, no matter what the market did, every single year we put out 140,000.
The ending balance down at the bottom right is about 1.1 million. So they didn’t totally erode their balance but lost almost half of their net worth. The second scenario we’re going to look at is same situation.
You have $2 million accumulated in an investment account invest in the S and P 500 those four years that the market was down. So 20 00 20 01 20 02 and 2008, we left the portfolio alone, did not take 140,000 out.
Instead we took 140,000 out of cash value inside of a life insurance contract. Let the equities recover. Ideally, once the portfolio recovers, you use the. The growth in the portfolio to pay back the life insurance.
But in this scenario, turning those four years off of portfolio distributions, ending net worth of this portfolio in the bottom right is $3 million. So that is a $2 million swing of just four years of a down market.
Cash value inside of a life insurance contract can be used as a safe asset and is actually the safest asset when compared to bonds or any fixed income. The growth of the cash value is going to be based on a dividend that the company pays out.
The insurance company. It’s really only a handful of companies we would ever do this with that have track records of paying dividends for the last 150 years back into the 18 hundreds. Most companies are paying about 6%.
And the internal rate of return, we can look for four to 5%. How this works there’s a built in guarantee inside of the life insurance contract. So if a company never paid a dividend, which there are companies that don’t, there is a guaranteed value that you would be contractually obligated to get back.
And then on top of that, there’s the dividends that the insurance company pays that gets reinvested back into the policy. So this example is putting $150,000 a year into a whole life policy that is funded for ten years total.
As you can see, this client is 35 years old. So when they are 55, policy is funded for ten years. So total put into the policy is 1.5 million. When they’re 55 to about 3 million, when they’re 65, to be almost 5 million, and when they’re 75, to be about 8 million.
And again, that is based on the contractual guarantee. And then the dividend that gets reinvested back into the policy that makes up for that growth. Bonds are fixed income. There’s a lot of interest rate risk.
So as interest rates rise, bond price drop. Meaning if interest rates are currently 3% and they are going up to six 7%, the bonds that were issued that are paying 3% interest are way less valuable because nobody want to purchase that.
When they could purchase a new bond worth six or 7%. With whole life insurance, there is no interest. Back at times of high interest rates. With the dividends that companies are paying out, they’re still generally historically have paid out over four or 5%.
So interest rates are not a risk with cash value life insurance as it would be with investing in fixed income, which would be another safe investment or asset class. As mentioned, a lot of these policies are oversold in the industry, mainly because a lot of times there are large commissions being paid out to the advisor, but important as a high net worth individual to pay the least amount of commissions as possible, especially because a lot of times they are funding large amounts of money into these policies.
So there are ways we can structure it. If too much money is put into a policy, it’s considered a modified endowment contract, meaning it’s not considered a life insurance contract and all of the growth then becomes taxable.
But you’re able to spread this out over ten years, gets a lot of the money in upfront and then allows after ten years you no longer fund it and then the growth continues to accumulate throughout the rest of your life.
Implementing whole life insurance is definitely situational depending on your family’s goals and net worth, but we have found it very valuable as a safe asset class for asset protection, for taxes and for safety with high net worth families.
So for any questions specific to your financial situation or plan, feel free to reach out.