With a new generation of young adults coming to age in an economic landscape that has seen sharp economic and falls following the Great Recession and COVID-19, cash value life insurance holds a unique position in the landscape of savings, risk tolerance, and certainty.
Rather than being seen through a black-and-white lens as either “expensive life insurance” or a “poor investment,” there is a groundswell of commentary that recognizes the unique position cash value life insurance holds in the financial universe.
While studies show that cash value life insurance has declined in overall popularity in recent years, it continues to be a popular choice among the wealthy. Top earners and those with significant financial assets use cash value life insurance policies as both a financial strategy and protection strategy. It offers families protection against human loss, as well as a way to create good savings habits and tax strategies.
Young people with high self-discipline and risk tolerance are more likely to save using permanent life insurance. Analyzing behaviors and financial habits of individuals born between 1980 and 1984, a National Longitudinal Survey of Youth found that ownership of cash value life insurance policies increased alongside self-discipline and decreased alongside risk tolerance.
One of the more prominent commentaries on this new perspective toward cash-value life insurance comes from a 2008 report by Richard Weber and Christopher Hause titled Life Insurance as an Asset Class: A Value-Added Component of an Asset Allocation. As part of their findings, Weber and Hause concluded that permanent life insurance can optimize the risk/reward profile of other assets.
That is, a portfolio with both fixed and equity components may offer a greater legacy when held in conjunction with a permanent life insurance policy. In other words, the guarantees of a life insurance policy, combined with the steady growth of cash value, can act as a buffer against stock market volatility.
In determining how to pay for permanent life insurance, Weber and Hause make another important statement: “…consumers may wish to consider paying premiums from portfolio resources rather than from income resources.”
Acquiring Insurance Through Asset Transfers
A simple example of asset transfer would be using the earnings (such as interest or dividends) from one asset to pay the premiums for the new asset (the permanent life insurance policy).
In fact, Weber and Hause take seven pages of their 100-page report to conduct an in-depth financial analysis of this asset-transfer approach, using earnings from a bond portfolio. The end result: greater accumulation, plus increased benefits.
Other methods of asset transfer:
Depending on the makeup of the assets in one’s portfolio, using earnings to fund annual premiums may not be feasible. Perhaps the principal is not large enough to generate the earnings each year. Or maybe the other assets appreciate in value, yet do not distribute interest or dividends.
Even if the principal is large enough, some assets may be volatile, and market fluctuations could make it hard to rely on them for ongoing premiums. Also, any transfer from your financial strategy may include an ordinary income tax consequence and a tax penalty on the transferred amount.
In any of these circumstances, it might be desirable to transfer the asset into permanent life insurance in one transaction, i.e., a one time payment instead of annual premium payments. This can be done; the challenge is determining how best to make the transfer.
Single-premium life insurance policies can be used for asset transfers. With this type of policy, one premium secures the life insurance benefit and establishes a cash value account that grows over time as non guaranteed dividends are credited.
However, current tax law on single-premium policies restricts or diminishes some of what Weber and Hause term the “living benefits” of a permanent insurance contract. Specifically, a single-premium insurance policy forfeits the tax-favored access to cash values via either partial surrenders or loans. These restrictions apply to both single-premium policies and any cash-value life insurance policy classified as a Modified Endowment Contract (MEC).
A MEC policy is a policy that has been overfunded according to the IRS. The MEC guidelines are quite complicated and exist to discourage the manipulation of permanent life insurance policies into artificially tax-favored “investments” instead of true insurance policies. Withdrawing money from a cash life insurance policy that has been classified as a MEC will mean facing the same rules that apply to withdrawing annuities, including paying income tax on the withdrawal and possibly a 10% early withdrawal penalty if you are less than 6 months past your 59th birthday. For most individuals who want to include permanent life insurance in their financial portfolio, avoiding the MEC classification is preferred. To read about how MEC guidelines have recently changed, read our article on the 7702 plan.
Premiums Paid in Advance
To avoid the MEC classification, yet allow policyholders to fund a permanent policy with one payment, some life insurers offer another option: premiums paid in advance. The rules vary by insurance company, yet usually follow this format: After underwriting approval for an insurance policy has been authorized, the insurance company will allow the policy owner to “pre-pay” future premiums to an account with the company. These premiums will be credited with interest and gradually transferred to pay future policy premiums.
Suppose the annual premium for a 10-pay whole life policy is $5,000. Under normal payment methods, the policy owner would pay $50,000 over ten years to fully fund the policy, without achieving MEC status.
In an arrangement to accept the ten years of premium in advance, the insurance company gives a discount to the policy owner, reflecting the interest the company will add to the deposit.
In this example, the insurance company is crediting a 4.75% annual return for the first 10 years of the agreement. Thus, instead of requiring $50,000 over ten years, the one time premium-in-advance amount is $40,938.
Each year on the policy’s anniversary, $5,000 is transferred from the advance premium account to the policy. At the end of ten years, the advance premium account is empty, and the policy is fully funded. This arrangement allows the policy owner to establish the permanent insurance policy with one payment—with all the legacy and living benefits—even though the policy will not be fully paid-up for 10 years. Note: ordinary income taxes apply to the interest earned in the premium account.
There are other important details in connection with this advance premium arrangement, which will vary by company. Typically, there is a limit on the amount that can be deposited, and a limit on how many years can be paid in advance. With this agreement, the policy owner cannot withdraw the balance from the premium account without also surrendering the insurance policy. If the policy is surrendered, the company may charge a surrender fee against the advance premium balance. Additionally, the interest credited to the account will be reported as income, which may or may not result in additional taxes.
Why Use the Advance Premium Payment Option?
Paying insurance premiums from existing portfolio assets annually often requires holding some funds in a safe and liquid account. Currently, these types of accounts may not offer annual returns or guarantees as attractive as the crediting rate in the insurance company’s advance premium account. If you already know this money is earmarked for premiums, and when securing permanent life insurance is the objective, the advance premium option may increase returns and benefits while minimizing financial risk.
Or, suppose you just realized a large gain from another asset in your portfolio; such as selling a property or liquidating a stock position. With that “windfall,” you hope to secure life insurance. The advance premium account serves as a conduit to affect the transfer in a clean and efficient manner. With one deposit, the life insurance program is established or secured (the agreement can pay for existing policies, not just new ones).
Of course, whether an advance premium payment option is appropriate depends on your unique circumstances. However, if you are currently paying insurance premiums from other existing assets rather than income, see if this approach could enhance your asset transfer process. Interested in learning more about asset transfers, and whether they can help you secure life insurance? Contact us or email firstname.lastname@example.org to get personalized assistance. We’re here to help!