The Best Kept Secret of Financial Planning for Americans
I’d like to know what you think- will this strategy remain valid in this scary new world we’ve entered???
comment below or write to info@thelondonamerican.com
Here’s an article by an expert named Norse Blazzard
VUL as a Tax Avoidance Strategy…
The Best Kept Secret of Financial Planning?
Conventional wisdom says that in the current world, anyone with a house and a set of golf clubs is probably a millionaire. While this may be overstating the case, it is clear that there are more “wealthy” people in our country today than was the case only a few years ago. Preservation of that wealth for the creators of it and for the natural objects of their bounty is a laudable goal—a goal that is uniquely possible with variable universal life (VUL) insurance as a major financial planning tool.
By Norse Blazzard, JD, CLU
VUL as a Tax Avoidance Strategy…
With the last market downturn, many market driven financial products have tested the investor’s resolve. This article provides a proper perspective on why Variable Universal Life Insurance is still uniquely positioned to provide benefits to a financial plan that don’t exist elsewhere.
Why Variable Life Insurance?
Variable life insurance is uniquely suited to the financial planning needs of most Americans. Distributions on death pass as “death proceeds” and are free from federal (and most state and local) income taxes on the investment gains in the policy. Thus, variable life insurance affords what is probably the most tax efficient method to convert otherwise taxable investment income into the tax-free financial security of loved ones on the death of the insured. In addition, certain types of variable life insurance policies permit pre-death loans to be made from the policy without any tax on the investment gains attributable to the policy. Thus, pre-death liquidity is also an important feature of the product.
Variable Life Insurance – The tax planning aspects
There was an associate justice of the United States Supreme Court who once opined that the nature of the federal income tax was so pervasive in our national psyche that no decisions were made by anyone in our country without taking into consideration the tax implications of those decisions. The federal income tax (accompanied by estate and gift taxes) have spawned huge industries in our country, it can be argued that the major use of life insurance is to accomplish tax- planning goals.
Life insurance policies still provide the most tax-effective method for people to transfer wealth to future generations. However, these products also provide for lifetime advantages that are unique. Therefore, if all our decisions are made with the tax consequences in mind, life insurance in general, and variable life insurance in particular, should always be at the forefront of our financial minds.
The recent downturn in the stock market may cause us to wonder why there is this article about variable life insurance. After all, we reason, variable life insurance is driven solely by corporate stock investments. Therefore, if corporate stock is not growing in value, why talk about variable life insurance? This article will attempt to point out some of the advantages of variable life insurance, the inherent flexibility of the product, and fact that it can provide financial planning advantages that cannot be obtained with any other type of financial product.
Investment Change With No Tax Consequence
We often hear that variable life insurance is not as good a purchase as would be the purchase of term insurance and a mutual fund or other stock investment. However, a variable life insurance product is far more flexible than the program of “buy term and invest the difference” that is recommended by many financial planners. This is because the variable life insurance product, like the variable annuity, permits a change in the underlying investments without any recognition of gain for tax purposes. This feature has been particularly valuable during the past two years of downward trends in the stock market!
If a person buys term insurance and invests the difference in mutual funds and the economic climate changes and she wants to change her investment orientation, she must redeem her mutual funds, pay capital gains taxes on any gain in the value of the assets and reinvest the amount left over in the new investment. With a variable life insurance policy, the same person can change underlying investments (including changes into fixed return or guaranteed forms of investment) without recognition of gain for tax purposes.
Thus, it is possible to “lock-in” investment gains while changing the entire investment orientation of the product.
The investments that underlie the most popular variable life insurance products provide much of the same types of mutual find investments that would be used with “buy term and invest the difference” programs. The main difference is that the investor must pay the income taxes when the mutual funds are sold at time of death, but death proceeds from the variable life insurance policy are distributed tax free!
Variable life insurance policies offer a wide variety of possible underlying investments in much the same way as is possible with variable annuities. Most such products are a combination of fixed and variable products with investment guarantees available for all or some part of the cash value of the policy. This makes it possible to tailor a policy for individual investment needs of the policy owner, tax or estate planning purposes.
Variable Life Insurance as a Retirement Planning Tool
Variable life insurance provides not only the ability to pass death proceeds on a tax-efficient basis, but it can also provide a valuable retirement planning advantage. Section 1035 of the Internal Revenue Code permits the tax-free exchange of a life insurance policy for an annuity contract. Therefore, it is possible for an owner of a variable life insurance policy to have the protection against financial problems from premature death during the bulk of life and then to exchange the policy for insurance against living too long when the death benefit protection is no longer needed. Variable life insurance in uniquely suited to provide protection against premature death a, while also providing protection against outliving funds available for retirement.
The Nature of the Product
and the Entities Involved.
As the product has developed in the United States, variable life insurance today means “variable universal life insurance.” The product utilizes some unique structures that were pioneered in the US and are rapidly being adopted around the world.
The first unique structure is the use of “segregated asset accounts.” Known throughout the life insurance industry as “separate accounts,” these are pseudo legal entities that are established by the life insurers pursuant to state insurance law. Separate accounts are used to hold assets that underlie various types of insurance and annuity contracts. The assets held in the separate accounts are segregated and held apart from the other “general” and separate account assets of the insurer. The insurer owns the assets held in these separate accounts. However, they are not, to the extent proper legal procedures have been implemented; chargeable with liabilities arising from any other business the insurer conducts. Moreover, to the extent that they represent insurance reserves and other contract reserves, these assets are for the exclusive benefit of the policies and contracts issued under the auspices of the separate account.
People often get hung up on understanding how variable life insurance works. Technically, variable life insurance is identical to traditional universal life insurance except that the investment increment credited to the cash values, and therefore the face amount of the policy, are determined by the investment performance of the separate account that underlies the product, rather than on the amounts credited by the insurer. In effect, the investment risk/reward is shifted from the insurer to the policy owner. Aside from this investment element, the mechanics of the insurance are roughly equal to hose in a traditional “fixed” form of universal life insurance.
Tax Issues
Previously, it was noted that the earnings in VUL’s investment divisions accumulate on a tax-deferred basis. By deferring current income taxes, your money benefits from the power of compounding. Most VUL policies permit policy owners to access almost all of the cash value via a policy loan provision. Usually, policy loans are tax free, but the overall amount of insurance coverage may decrease due to any outstanding loan balance.
Mutual funds are also fairly liquid investments. There are no loan privileges and withdrawals of earnings may be subject to surrender charges and current income taxes. VUL policies may also charge a surrender charge for withdrawals. In addition, the tax treatment given to funds in a VUL policy is on a first-in, first-out (FIFO) basis. This is advantageous should you wish to create a stream of income at retirement. One potential option involves receiving withdrawals until reaching your cost basis, then changing the method of withdrawals to policy loans. Partial withdrawals are at net asset value, which may be more or less than the original price. Withdrawals may be taxable and, if under age 59 ½, may be subject to a tax penalty. Assuming the policy has been in force for at least fifteen years and remains in force through death or maturity, this arrangement would avoid a taxable event on the funds withdrawn. Remember that policy loans on withdrawals will reduce the policy’s cash value and death benefit.
Death Benefit Proceeds
Protecting loved ones is one of the fundamental reasons for purchasing any type of insurance. Both VUL and term insurance policies offer a death benefit. And, both policies can be structured so your beneficiaries receive the proceeds estate and income tax free.
Other Issues to Keep In Mind
(These below may vary from state to state)
In addition to the above comparisons, keep the following points in mind:
· You can use VUL’s cash value as a liquid account.
· You can use VUL’s cash value as collateral when applying for a bank loan. This does not hold true for term insurance, as it does not have a cash value component.
· VUL’s death benefit (which may include tax deferred accumulations) is free from probate. This does not hold true for mutual funds.
· Withdrawals and loans from the cash value of a VUL are tax-free as long as the policy remains in effect.