Finding, and utilizing, your free money sources

Using Indexed Universal Life Insurance

By Kristin O. Bulat JD, LLM

Ms. Bulat is an Attorney for the Advanced Markets Group at John Hancock Life Insurance Company, Boston, MA. If you have any questions about this article, you can email her at kbulat@jhancock.com

Free money. We would all love to be the recipients of free money, but since the Free Money Fairy retired, we have to settle for the second-best alternative: income tax-free money. But where do we get income tax-free money? One of the most efficient sources is through life insurance.

Insurance 101 teaches us that life insurance is taxed on a first-in, first-out basis, which means that the premiums paid into a life insurance contrac can be withdrawn from the policy without paying income taxes. Of course, the next dollar withdrawn is considered gain in the policy and would be subject to income taxes. To avoid that gain, the policy owner can switch from withdrawals to loans, and as long as the policy isn’t allowed to lapse, those loans aren’t currently taxable as income to the policy owner. The outstanding loan, plus any accrued interest, is then repaid from the policy’s death benefit at the insured’s death.

Now that we’ve established where to find income-tax free money, we need to work out how to maximize that money and to set the best time to receive those funds. Most income-earners foresee their greatest need for income after they have retired, and are no longer earning an income. Those individuals are putting as much as possible into their company-sponsored retirement plans, but they still feel as though they aren’t saving enough. In addition, they know that any post-retirement monies coming out of their retirement accounts will first be subject to income taxes.

Let’s assume that we have a 45 year-old woman who is working for a company in Massachusetts. She is already funding her retirement plans to the maximum allowed and she is really excelling at her job. As a result of her professional success, her employer wants to give her a $30,000 annual bonus to help her fund her retirement. After she pays her assumed 30% income tax rate on the annual bonus she has $21,000 to invest toward her retirement. She has come to you for advice.

Where your new client has just paid $9,000 of her annual bonus to income taxes, she is very interested in the idea of creating a pool of funds that she can receive income tax-free. She also lived through the 2008 decline in the stock market, and although her investments are beginning to recover, she’d like to take steps to minimize the impact that a down market can have on her retirement investments, while earning more than the income generally available from investing in income tax-free municipal bonds.

You can suggest an indexed universal life insurance contract (IUL). An IUL contract is a cash accumulation-focused life insurance contract that has the potential to generate significant cash values inside the contract and provide a death benefit to her heirs. This cash value is accumulated through up to three premium allocation options offered by an IUL contract, all of which provide competitive choices for any level of risk tolerance. Your client can allocate her premiums through the way in which the policy’s cash value is divided: into a fixed account, a capped index account, or an uncapped index account.

The fixed account is exactly what it sounds like; it credits at a declared crediting rate providing strong, stable performance to the policy. If your client were to choose to allocate her premiums to the fixed account, those premiums would receive an annual credit of approximately 5%. The fixed account is an important element to an IUL contract and it should not be overlooked when the policy owner is deciding on a premium allocation for the IUL. Dedicating some of the annual premium to the fixed account is an allocation option that can balance the volatility of the various indexed accounts and provide stability in later years for policy owners who seek more consistent results during retirement. The fixed account also provides an additional hedge against the risk of underperformance by the S&P 500. However, if your client wants to pursue potentially greater returns than a fixed account’s crediting rate of 5%, she should consider the premium allocation options of either, or both, the capped index or uncapped index accounts.

The index accounts on an IUL contract are generally related to the annual performance of the S&P 500. The two indexed account options share common characteristics in everything except how they credit interest. Both index account options create ‘segments’ that mature after one year, with credit interest based on annual point-to-point changes to the S&P 500, and guarantees to never credit less than 0%. This minimum crediting of 0% means that even if the market has a negative return for the year, as it did in 2008 with a return of -37% neither of the indexed accounts in an IUL contract would receive a negative crediting rate. The difference between the capped and the uncapped crediting rates is the ability of the account to participate in the market’s performance, based on the portion of the S&P 500 performance that’s credited.

Where your new client has just paid $9,000 of her annual bonus to income taxes, she is very interested in the idea of creating a pool of funds that she can receive income tax-free. She also lived through the 2008 decline in the stock market, and although her investments are beginning to recover, she'd like to take steps to minimize the impact that a down market can have on her retirement investments, while earning more than the income generally available from investing in income tax-free municipal bonds.

Typically a capped index account credits a range, for example – between 0% and 13%. This means that the capped account does not suffer any of the downsides to market risk, but it is limited in its participation in the market’s upside. The capped index account is for policy owners who seek some of the upside potential of equities without risking negative returns. The uncapped index account typically credits a 0% floor and up to the full performance of the S&P 500, less a spread (for example, around 5.5%). Uncapped index accounts are for policy owners who are optimistic about potential equity market performance, and are willing to accept more potential volatility in exchange for more upside potential.

S&P 500Capped IndexUncapped Index
PerformanceAccountAccount
25%13%19.5%
15%13%9.5%
5%5%0%
-5%0%0%

 

The above chart shows a hypothetical example of what would be credited based on hypothetical S&P 500 performance and the assumed current cap and threshold rates: In general, there is some flexibility of allocation options; your client would not have to allocate her premiums 100% to one premium account option. She can create her own allocation based on her personal objectives, and can change her allocation as her needs and circumstances change. Let’s explore what a typical IUL contract might look like when your client retires in 20 years, if she chooses to allocate her $21,000 of available premiums, 20% to the fixed account 60% to the capped account, and 20% to the uncapped account.

The numbers shown for this hypothetical IUL contract are based on an assumed rate of around 5% for the fixed account, a rate of around 7.8% for the capped indexed account, and a rate of about 8.00% for the uncapped indexed account.

Based on those hypothetical crediting rates, an underwriting class of preferred nonsmoker for a 45 year-old female and a scheduled premium of $21,000 for 20 years, your client could typically buy an IUL contract with a death benefit of approximately $580,000. In addition to the approximately $580,000 of death benefit, the non-guaranteed cash values inside the policy when the client reaches age 65 would be in the neighborhood of $770,000. The projected policy would have sufficient cash values to allow your client to withdraw about $50,000 for almost 9 years, until her basis is used up. In the 10th year she would switch to taking $50,000 in annual loans from the policy. At her assumed tax bracket of 30%, in order to net $50,000 after-tax, your client would have to have annual income in excess of $70,000.

If your client continues to take $50,000 from her IUL contract, by the time she reaches age 80, she will have withdrawn $750,000 income tax-free from the policy. With a typical contract, in year 81 she would have a non-guaranteed cash value of over $1,000,000 and her death benefit would be nearly double, increasing to over $1,000,000 (without taking the outstanding policy loan and loan interest into account). This means that she could continue taking the $50,000 from the policy or she could stop the withdrawals and allow the policy to continue, which increases the net death benefit.

Although free money is nothing more than a myth, income tax-free money can be a definite reality for your clients. Through the use of an indexed universal life insurance contract, your client can maximize her income tax-free money while still preserving a death benefit to go to her heirs or to her surviving spouse. Through utilizing the combined benefits of the income tax-free nature of life insurance, and the potential upside in the S&P 500, your clients can generate substantial additional.