LISTEN Asset Transfers (mp3audio) (9:57 min)
Perhaps coinciding with the economic fallout from the Great Recession, the past few years have seen some significant adjustments by financial experts in regard to cash value life insurance. 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.
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 an investment portfolio. That is, a portfolio with both fixed and equity components that includes life insurance intended for a lifetime, may deliver greater legacy and living values in conjunction with the investment portfolio – for a given risk tolerance and reward goal – than the portfolio without the intended life insurance.
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.
This is the idea of acquiring life insurance through asset transfers. A simple example of asset transfer would be using the earnings (such interest or dividends) from one asset to pay the premiums to establish a 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:
Single Payments — 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 necessary earnings each year. Or maybe the other assets appreciate in value, but 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 a qualified plan 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 a gradual year-by-year series of transfers. 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 which grows over time as nonguaranteed 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 the tax-favored access to cash values via either partial surrenders or loans. These restrictions apply not only to single-premium policies, but any cash-value life insurance policy classified as a Modified Endowment Contract (MEC). 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. For most individuals who want to include permanent life insurance in their financial portfolio, avoiding the MEC classification is preferred.
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 with the insurance company, but 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. Here is an example from a leading life insurance company, reflecting current rates.
Suppose the annual premium for a 10-pay whole life policy is $5,000. Under normal payment methods, the policyowner would pay a total of $50,000 over ten years to fully fund the policy, but not achieve MEC status. In an arrangement to accept the ten years of premium in advance, the insurance company gives a discount to the policyowner 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 policyowner to establish the permanent insurance policy with one payment – with all of 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, as well as a limit on how many years can be paid in advance. With this particular agreement, the policyowner 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. Also, the interest credited to the account will be reported as income, which may or may not result in additional taxes.
Why would someone use the advance premium payment option? Paying insurance premiums from existing portfolio assets on an annual basis usually 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 adding permanent life insurance to one’s portfolio is the objective, using the advance premium payment option may be another way to increase returns and benefits, while minimizing financial risk.
Or suppose you just realized a large gain from another asset in your portfolio; a property was sold, a stock position was liquidated. You have a significant gain you want to transfer to a secure asset, such as permanent 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 either established or secured (the agreement can be used to pay for existing policies, not just new ones).
Of course, whether an advance premium payment option is appropriate depends on your unique circumstances. But if you are currently paying insurance premiums from other existing assets rather than income, you may want to see if this approach could enhance your asset transfer process.
