Tax Free Interest Crediting

Mark Sherwin + Ibbotson
Mark Sherwin + Roger G Ibbotson (Yale School of Management)

The use of the phrase “good investment” with life insurance has long been an oxymoron. Traditional life insurance products have had too few investment options for sophisticated investors such as business owners and high net worth individuals. This phenomenon has occurred in spite of the significant tax-advantages that life insurance enjoys in comparison to other financial products.

Ibbotson + Schiller
Roger G Ibbotson (Yale University) + Robert Schiller (Nobel Prize in Economics, Yale University)

Tax Advantages of Life Insurance

Life insurance has enjoyed significant tax advantages. In general, life insurance offers five distinct tax benefits:

  • Tax-deferred “inside build-up” of policy cash values under Internal Revenue Code of 1986, as amended (“IRC” or “Code”) Sections 7702 and 817.
  • Non-recognition of capital gains, allowing the taxpayer to switch investment options within the policy without triggering taxation, under IRC Sections 7702 and 817.
  • Tax-free access to policy cash values through a partial surrender of the cash value or through low-cost policy loans. IRC Section 72 (e).
  • Income tax-free death benefits. IRC Section 101(a).
  • Estate tax-free death benefits through the use of an irrevocable life insurance trust (“ILIT”). IRC Section 2042.

The legislative intent behind these tax-advantages is rooted in social policy designed to encourage household savings and insurance protection.

Benefits of using Indexed Universal Life Insurance (“IUL”)

During a year of growth, the IUL account value will participate in typically 100% or more of the underlying index gains, via linkage to the published returns of the various indices (S&P 500, NASDAQ 100, DJIA, Russell 2000, etc.).

During a subsequent down year, an IUL principal and accumulated gains are locked in and carried forward (annual reset) to the next contract anniversary.

If the markets should recover the following year, the IUL account value again participates in those gains without having to recover from the previous  year’s correction.

Not only do securities not provide this safety from market declines, but an investor can lose substantial portions of both principal and past earnings during a market downturn often requiring extreme market gains just to get back to even. Because of the absence of a potential drop in the IUL account value due to market losses, IUL qualifies as a fixed product under the licensing regulations with the Department of Insurance Commissioners of all 50 states.

IUL account values grow tax-deferred like a traditional IRA and 401(k) plan. Simply put, this means that your IUL account value benefits from triple compounding:

  1. You earn interest on your principal

  2. You earn interest on your interest

  3. You earn interest on the money you would otherwise have paid in taxes

Unless held in a qualified plan, securities gains are annually reportable and taxable, thus denying an investor the benefits of such three-fold compounding. Although qualified plans are a better choice than non-qualified plans, they still have issues not present with an IUL. Plan investment choices are normally limited to mutual funds where your account value is subjected to wild volatility from exposure to market risk.

There are no limitations on the amount that may be contributed annually to an IUL. As of the date of this article, the IRS limits the annual contribution to an IRA to $5,500 annually if the account owner is under the age of 50 and $6,500 annually if the participant’s age is 50 or higher.

Policy owners may access their money from an IUL without IRS penalty regardless of age. Qualified plan withdrawals prior to age 59 1/2 are subject to a 10 percent penalty in addition to being taxed as ordinary income for the year the withdrawal is taken.

You control your taxes, not the fund manager. IULs grows tax-deferred, and are never taxed if taken in the form of policy loans. This allows owners to control precisely if, when and how much money will be taxable, depending upon their needs and circumstances.

 

An IUL grows tax-deferred, cannot lose value in a market downturn and imposes no annual tax reporting as it is increasing in value.

The keeping of excellent records is often one’s only defense in the event of an IRS audit. With an IUL, one’s records are kept by the insurance company, copies of annual statements are mailed to the owner, and distributions (if any) are totaled and reported at year end.

The proceeds of the IUL policy is always a non-probate distribution that passes outside of probate directly to one’s named beneficiaries, and is therefore not subject to one’s posthumous creditors, unwanted public disclosure, or similar delays and costs. Your heirs receive their insurance proceeds within weeks, not months or years after your passing.

An IUL can provide their owners with a stream of income for their entire lifetime, regardless of how long they live. Insurance is often classified so that it is not considered assets for Medicaid disqualification of nursing home costs. This is beneficial when organizing one’s affairs, and converting assets to income prior to a nursing home confinement. 

All policies will allow an owner’s easy access to cash in their policy, often waiving any surrender penalties when such individuals suffer a serious illness, need at-home care, or become confined to a nursing home. 

IULs allow the tax-free exchange of one policy for another. An indexed universal life insurance policy owner may exchange their policy for a completely different policy without triggering income taxes. 

IULs provide cost-free asset rebalancing. This option is usually available among the major index choices (the S&P 500, NASDAQ, DJIA, Russell 2000, etc.), as well as a fixed interest option, at policy anniversaries. 

There are even more reasons why knowledgeable investors prefer this remarkable savings vehicle, such as how the account value can be used to:

  1. fund major purchases

  2. college education

  3. medical expenses

  4. retirement income

  5. any other cash need and continue to grow as if the money had never been used.

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