When advisors think of a protective wealth building/retirement tool, many think of fixed/equity indexed annuities (FIA).  Why?  Because FIAs provide clients with "principal protection" (the money in a FIA can not be reduced due to market forces) and decent upside potential if the chosen stock index performs well (FIAs should return 4.5-6.5% on average annually).  Generally speaking, FIAs are used most for clients 60 years and older who are in or near retirement (unless the Maximizer is used to build wealth and then FIAs are purchased by clients of any age). (For more info. on the Maximizer, please click here).

            On the other hand, a cash value life insurance policy is used by clients to grow and protect their wealth who are typically under the age of 65 due to the fact that the cash grows tax free and can be removed tax free in retirement via policy loans).  For liquidity reasons and due to mortality costs, cash value life insurance used in its traditional form is often not a good choice for clients over the age of 65.

            In order for a cash value life insurance policy to be a viable tax-favorable retirement vehicle, the policy must be “over funded” with cash and the initial death benefit of the policy needs to be at the lowest possible amount allowed by the Modified Endowment Contract (MEC) rules. If the insurance policy becomes a MEC, any borrowed funds from the policy in excess of the basis (premiums paid) are treated as taxable income (similar to a tax deferred annuity)

            “Back in the day” (before the MEC rules) there used to be such things as single premium life insurance policies where clients would pour hundreds of thousands of dollars in year one into the policy where the death benefit was very low. This makes a lot of sense considering the client is buying the policy to build wealth and not for the death benefit.  The more money and the quicker a client can fund their life insurance policy, the more tax free growth and retirement income an insured will have (assuming the death benefit is not too high). 

            Because of the popularity and tax favorable nature of the old single premium cash value life insurance policies, Congress passed what we all affectionately call the MEC rules.  The MEC rules established a 7 year corridor where the premiums paid over that period of time drive the “required” death benefit an insured MUST purchase in order avoid the policy from becoming a MEC. 

            For example, “back in the day” a client (55-year old male) might have been able to pay a premium of $100,000 in year one into a cash value life insurance policy and have the death benefit be very low (let’s say $270,000).  Because the death benefit is so low, the policy has a massive amount of cash that will grow and can be used in retirement. 

            If that same client tried to over-fund the policy with a $100,000 one-time first- year premium payment under today’s MEC rules, the initial death benefit the insured would have to purchase to avoid having the policy deemed MEC would be $1.56 million dollars. 

            There is a HUGE difference in costs to the insured when comparing a policy with a $270,000 initial death benefit and a $1.56 million dollar death benefit.  The MEC rules make it financially unattractive to short-fund cash value life insurance with the purpose of obtaining the maximum tax free retirement benefit.  That’s why when planners counsel their clients they recommend that premiums should be paid into a cash value policy over a 5-7 year period.  This helps comply with the MEC rules and will significantly lower the required death benefit (which in turn will increase the cash value).

            The million dollar question: Is it better for a client to fund a Fixed Indexed Annuity or over-fund a single premium life insurance policy that is treated as a MEC (remember that if the policy is a MEC, any accumulation of cash in excess of premiums paid is treated as taxable income)?

            The best way to illustrate the answer is with an example.

            Let’s take Dr. Smith who is 55 years old and in good health. Assume he has an extra $100,000 sitting in a money market account that he would like to reposition somewhere safe where the money will grow tax deferred and can be used in retirement.

            The options I will illustrate in this newsletter for Dr. Smith to build wealth are to fund a Fixed Indexed Annuity (FIA) or an Equity indexed Life Insurance (EILI) policy (i used my favorite policy Revolutionary Life).

            Let’s assume Dr. Smith will fund, in year one, $100,000 into a FIA and $100,000 in year one into the cash building life insurance policy (which will have a very low death benefit and will be considered a MEC).

            Which one will provide more retirement income for Dr. Smith when he turns 66 years old?  I’m going to assume he will spend down the assets in an equal amount for 20 years.

            Let’s assume the FIA returns 5.5% annually and that the EILI policy has returns of 7.5%.  Why the difference in return?  Because a FIA will typically have a cap on earnings annually of between 7-9% of the measuring stock index and the EILI policy will have caps between 12-16% depending on the policy used.  Because there are higher caps on the annual growth in the EILI policy, the annual returns should be higher.

            How much can Dr. Smith remove annually from his FIA when reaching the age of 66?

            $13,190 each year from ages 66-85

            How much can Dr. Smith borrow from his life insurance policy at age 66?

            $17,110 each year from ages 66-85

            I found it very interesting that the life insurance policy generated a return that is 23% better then the FIA.

            The tax treatment of the income from the FIA and the EILI policy is the same unless a client “annuitizes” the annuity.

            Let me change the variables a bit.

            The $17,110 number from the life insurance policy used a 7.5% interest rate on the funds Dr. Smith borrowed from his life policy from ages 66-85. As you found out from last weeks newsletter, EILI policies have what is called a variable loan feature in which experts believe there will be a positive spread between the crediting rate of the policy and the lending rate on policy loans.  To read about variable loans in life policies, please click here.

            What if the lending rate on policy loans is 6.5% (1% less then the crediting rate) using the variable loan option of the life policy?  Dr. Smith could remove $19,091 every year from ages 66-85.  30% better then the FIA.

            What if there is a 2% positive spread (which is what those in the industry predict)?  Dr. Smith could remove $21,202 every year from ages 66-85.  38% better then the FIA.

            Ask your clients if they would like to fund either a FIA or a MECed out cash value life insurance policy to fund for retirement where the EILI policy is positioned to  return 23-30% more income.  Which one is the client going to gravitate to?  Many will opt for the life insurance policy.

            If it were only that simple.  While the MECed life insurance policy does return significantly more money, there is an element of risk using the EILI policy vs. the annuity. Life insurance policies have more expenses than a FIA. These higher costs are offset by having higher caps and higher returns. However, if the policy does not perform well over the long term, an annuity will out perform it.   

            For example, if the life policy only returns 6.5% on average and if I used a 5.5% loan rate, Dr. Smith would be able to remove $15,428 from the policy from ages 66-85.   If the lending rate mirrored the 6.5% crediting rate, the amount Dr. Smith could remove from his policy is $13,792 from ages 66-85.

            What are the other benefits of funding a MECed life insurance policy over an annuity?

            1) When the client dies, the death benefit from the life insurance policy will pass income tax free to the beneficiaries (although not estate tax free unless owned by and ILIT). In the Dr. Smith example, if he were to die at age 85, there would be approximately a $50,000 additional death benefit that will be paid to the heirs which is not going to happen if a FIA is funded.

            2) The death benefit from the life insurance policy will almost always be greater than the account value inside the annuity. The initial death benefit at age 55 when the policy was purchased is $270,000 ($170,000 more then what the heirs would receive had they funded an annuity).

            Summary

            Is funding a MECed life insurance policy as a retirement vehicle a good idea?  It can be if designed properly and the client is healthy.  Because the EILI policies have much higher caps then FIAs, the returns should be 2%+ higher then the FIA (which in turn should provide the client with more retirement income).  

            In addition to the potential for more retirement income, there is a death benefit that will pay to the heirs income tax free (unlike the growth of the money in an annuity).

            I’m not advocating that advisors stop using FIAs and instead start selling over- funded MECed out cash value EILI policies instead.  I simply want readers to know that a client who would like better returns than what a FIA can offer while using a product that has principal guarantees, should consider using a MECed out life insurance policy as one of their wealth building retirement tools.

Roccy DeFrancesco, JD, CWPP™, CAPP™, MMB™

Founder, The Wealth Preservation Institute

Co-Founder, The Asset Protection Society

378 River Run Dr.

St. Joseph, MI 49085

269-216-9978

269-983-6917 (fax)

www.thewpi.org 

www.assetprotectionsociety.org

Are you a CWPP™,  CAPP™ or MMB™?  To learn more about the CWPP™, CAPP™, or MMB™ certification courses and how to take your consulting to the "next level" go to www.thewpi.org.

Author of The Doctor's Wealth Preservation Guide which can be purchased for $49.95 from The WPI at info@thewpi.org.

Circular 230 disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.