The Tax-Free Benefits Of Life Insurance
The three most common uses of life insurance are to:
Provide liquidity to fund lifestyle expenses for one’s family in the event of a pre-mature death.
Generate a tax-free supplemental retirement income.
Pay the estate taxes due when wealth is transferred to the next generation.
The tax-advantaged treatment of the cash value accumulation inside a life insurance policy is very appealing for those who want a conservative alternative to a taxable stocks and bonds portfolio. This tax-free benefit can also be enjoyed when taking tax-free retirement income drawdowns from the policy.
In addition, when a wealthy individual passes away, their assets can be passed on to their surviving spouse without tax consequence, however once their surviving spouse passes away and their wealth is transferred to the next generation, their heirs can incur a substantial tax liability in the form of estate taxes. The IRS allows a certain amount of their net worth to be transferred to the next generation tax-free up until a certain dollar amount known as the Estate Tax Exemption Limit. In 2017, the Trump Tax Act was enacted, giving individuals an $11,180,000 estate tax exemption starting in 2018 (up from $5,490,000 in 2017). This exemption has increased each year since then. Below, we see these increases since 2017 (sourced from https://www.irs.gov/pub/irs-pdf/i706.pdf ):
2017: $5,490,000 ($10,980,000 per married couple)
2018: $11,180,000 ($22,360,000 per married couple)
2019: $11,400,000 ($22,800,000 per married couple)
2020: $11,580,000 ($23,160,000 per married couple)
2021: $11,700,000 ($23,400,000 per married couple)
2022: $12,060,000 ($24,120,000 per married couple)
2023: $12,920,000 ($25,840,000 per married couple)
2024: $13,610,000 ($27,220,000 per married couple)
Upon death, a spouse can pass their exemption on to their surviving spouse. However what many feared regarding the Biden Administration’s tax agenda came to pass on September 13, 2021 when the House Ways and Means Committee released a tax change proposal in favor of reducing the estate tax exemption limit back down to the $7,000,000 range per individual in 2026.
However, one thing that has remained constant is the favorable tax treatment of life insurance, which is why it continues to be an incredibly valuable estate planning tool.
Due to Section 101a of the IRS tax code, the death benefit of a life insurance policy is tax-free, giving policy owners a huge advantage when the policy is owned in an Irrevocable Life Insurance Trust (ILIT) outside their taxable estate. It is important to understand that when a person dies, any excess net worth above the estate tax exemption is currently taxed at a rate of 40.00% when it is transferred to the next generation.
To clarify how this works, when one spouse passes away, the surviving spouse does not incur any estate tax liability. However when the second spouse dies and the estate is transferred to the next generation, estate taxes are incurred by the inheriting generation.
As an example, if the surviving spouse is worth $100,000,000 above the exemption limit, the inheriting generation will owe $40,000,000 in estate taxes (40.00% of the $100,000,000). This inheriting generation is only given nine months from the time of their surviving parent’s death to file and pay the estate taxes due, which is not much lead time by any means.
Even if the estate value is comprised of illiquid assets (e.g., real estate, a company, jewelry, art, automobile collection, etc.), the estate tax is still due on the value of these assets nonetheless, which often results in a necessary fire sale of such assets to come up with the funds required to pay the estate taxes. This can be both financially draining and emotionally taxing for all parties involved.
Life insurance is an extremely efficient tool in planning for the estate tax liability that the next generation will incur because it removes the need to liquidate the estate’s illiquid assets within this nine-month period. If the policy is owned by an Irrevocable Life Insurance Trust (ILIT) – which is outside the taxable estate – the death benefit will pay out tax-free to the ILIT and is not subject to estate taxes. The ILIT can then pay the estate taxes due once the death benefit is issued. This is a much easier process to manage than a desperate fire sale of illiquid assets just to come up with the cash needed to pay the estate taxes.
There are many benefits of using life insurance as both an estate tax planning tool, as well as a tax-advantaged asset for wealth accumulation and supplemental retirement income. But this is an industry wherein the explanations of how these insurance-based instruments actually work is opaque at best. One of the biggest criticisms of the life insurance industry is that many of the products lack transparency, and quite frankly, I would have to agree with that accusation… sort of, but not completely.
The reality is that many of these life insurance products do not lack transparency in their construction. The lack of transparency is in how their construction is communicated to the client – both from the carriers and the agents. It is a problem I experienced as a life insurance client back before I got into this line of work, and it is a problem that still exists today. To make things even worse, when the concept of premium financing is introduced into an already-opaque equation, the complexities, perceived risk, confusion, and skepticism grow exponentially.
That being said, I have the solution to these seemingly daunting issues and accusations. The key is to understand how different types of life insurance policies are built and how they work mechanically. This is the foundation I built my practice on. Everything I do is rooted in education and granular understanding.
When I talk to a client (or an advisor) about premium financed life insurance, I will open up the black box so you can see what’s actually inside the box, which will change your perspective from looking through opaque lenses to looking through a high-powered microscope. The strong stance I have taken on opening up this black box has at times felt like I was opening Pandora’s Box, but as I stated earlier, I am an industry disruptor – a beacon of transparency – and my goal is to teach you the truth about these products, where the risks are, how to mitigate these risks, and to show you the best way to utilize these products in the most effective way possible.
If you are not familiar with the details of the Greek mythological story of Pandora’s Box, indulge me for just a moment to share with you how analogous this story is to Premium Financed Life Insurance.
In Greek mythology, Pandora was the first woman on Earth. She was given a box that the gods told her contained special gifts, but she was also told that she was not allowed to open it and see what was inside.
Eventually, Pandora could not contain her curiosity and she opened the box. When she did, all the illnesses and hardships that the gods had hidden in the box started coming out. She tried to close the box once she saw the evil coming out of it, but in doing so, hope got trapped inside the box.
Many people feel the same way about certain life insurance products. They are told that the black box contains all kinds of special gifts (e.g., tax-free benefits, 0% floor, etc.), but they are told not to open the box and dissect its components at the granular level. In fact, I’ve even heard advisors say, “My clients don’t want to know all the details.”
Personally, I think that statement greatly underestimates the curiosity of high-net worth clients. To say that a person worth $100 million doesn’t want to understand how an IUL works is an incredibly naïve thing to say, and from my own personal experience, a very inaccurate thing to say.
My method of communicating the construction of a Premium Financed Life Insurance arrangement is to break down my explanation into following chronological sections:
The different purposes of life insurance within estate planning.
The concept of using leverage in the form of financing some or all of the premiums.
My backtesting and stress-testing methodology.
How interest rates and policy performance can impact the amount of collateral required.
How policy charges work.
How policy crediting works.
How a poor sequence of market returns can impact both short-term and long-term outcomes.
The history of the relationship between market performance and borrowing interest rates.
A comparison between premium financed life insurance versus a non-financed policy, versus a non-insurance based investment account after fees, capital gains tax, and estate tax.
Before I transition from section to section, I always tell the client, “I tend to get extremely detailed because I’m a math nerd, so if at any time I start getting too granular, just tell me you don’t need to know that much detail, and I’ll stay more conceptual and not get so granular.”
Guess how many times a client has told me to not explain the details to them. Not once. Ever.
When I started teaching advisors and their clients how Premium Financed IULs work at the granular level, my result was much different than Pandora’s because when I opened up the black box of IULs, not only did the evils of the life insurance industry come out, but so did hope. Sure, I exposed certain products and their design flaws (especially in premium financing), but I have also been able to uncover the truth about how a well-designed Premium Financed IUL can be one of the most valuable assets in estate planning that exists – assuming it is designed properly and used with the right client.
My approach to premium financing is to teach you how these products actually work – specifically the Indexed Universal Life Insurance (IUL) product – so that you fully understand not only the general concept, but the granular details as well.
I also teach clients and advisors several different ways to finance life insurance premiums because each specific financing arrangement should be custom designed for each specific client.
To access my book Premium Financed Life Insurance on Amazon, CLICK HERE
To access my book IUL For Aspiring Know-It-Alls on Amazon, CLICK HERE
