What’s all this talk we’ve been hearing lately on radio ads about “banking on yourself”? You may have heard the ad in which the guy says that if you’re thinking about putting money in the stock market, “Stop!” And then he goes on to say that with his program you can build wealth, not lose money, and even pay yourself interest on car loans. Too good to be true? Well, it’s not as crazy as it sounds.
This “special” investment is nothing more than good old-fashioned whole life insurance set up to maximize cash value growth and take advantage of the special tax treatment afforded to life insurance policies. Before I explain how it all works, a few concepts need to be understood:
Permanent Life Insurance: these kinds of policies are designed to last your entire life time and not expire or require huge increases in premium payments at the end of a term.
Cash Value: this built-in feature of many permanent life insurance policies allows a policyholder to accumulate cash within the policy on a tax-deferred basis.
Tax-deferred: means you don’t pay taxes on gains now but may pay them at some time in the future, if at all.
Guaranteed: refers to the minimum interest rate that the life insurance company guarantees it will pay on the cash value, regardless of the economy or the insurer’s investment returns; usually this will be a conservative amount, say 3% or 4%.
Non-guaranteed: refers to the current rate of interest that the insurer is actually paying right now on policy cash values, and can change depending on the performance of the insurer’s investment portfolio; this rate will often be higher than the guaranteed rate.
Policy Loan: a way of borrowing against the cash value of a life insurance policy at a minimal interest rate, rather than cashing out the policy or taking out a policy withdrawal. Policy loans are not generally taxable, and do not have to be repaid.
Dividend: a policyowner’s share of the insurer’s annual profit that can be added to the policy’s cash value to increase cash value even more than would be earned by the interest rate alone. Dividends are not guaranteed.
So how does this program work? First, you apply for a life insurance policy through a reputable agent or broker from a high quality insurance company. It is important that this policy be properly funded, and this should be discussed with the agent/broker as it is beyond the scope of this short article to explain adequately. But the basic goal is to overfund the policy, meaning you deliberately pay extra money into the policy, over and above the actual premium needed to keep the policy in force.
This extra money goes straight in to the cash value portion of the policy, and allows the policy to grow more cash more quickly than would normally occur if you paid only the required minimum premium. Remember, this cash is growing tax-deferred, so any gains made this year will not be taxed next April 15th. Why is that good? Because you will continue earning interest not only on your principal, but also on the money that you didn’t have to pay to the government as a tax.
To understand why that’s important, think about your regular bank savings account. Each year that you earn a gain in your savings account, your bank sends you a tax reporting statement the following January showing how much interest you earned. Then you have to pay a tax on that gain. By paying this tax you actually lose some of your profit to the government. But because life insurance earns interest on a tax-deferred basis, you don’t have to pay taxes on your interest gains each year. And that means you have more money working for you earning more interest than you would if you had to pay part of the profits to the taxman. This is similar to the benefit you get by investing in a 401(k) or an IRA.
What does this mean in practical terms? Say, for example, that the guaranteed interest rate on the policy is 4% and your combined federal and state income tax rates total 33%. You would need to earn an annual gross rate of about 6% on a currently taxable investment to earn a net of 4% after taxes. On the other hand if you invest money in a taxable vehicle that earned 4% before tax, you’re after-tax gain would be only about 2 1/2%. So what would you prefer? Earning money that’s taxed every year or that is tax-deferred? And at current bank interest rates, can you even get 4% on your savings? Can you get 3%?
Ok, so you have an insurance policy stuffed full of cash and now you want to use some of that cash. Maybe you want to finance a new car, take that round-the-world vacation you’ve promised your spouse, help the kids with a down payment down on a house, or help the grandkids pay for college. How do you do that? And, just as importantly, how do you do that without having to pay all those taxes on your gains that have been accumulating for years? The answer: policy loan.
Unlike a conventional loan from a bank, credit union, or finance company, you don’t have to qualify to borrow against your policy - it’s already your money. All you have to do is contact your agent/broker or the insurance company and request the loan. They’ll send you the appropriate paperwork to sign and you’re all set. No credit checks, no examination of your income and tax returns, no embarrassing questions. And instead of paying the principal and interest to the lender, you pay it back to your policy. That’s right, you pay it back to yourself. Yes, the insurance company takes a small portion of the monthly pay-back amount, and that is good because it allows you to use your money, including your gains, as a loan rather than as an income distribution. Remember, loans are not taxed as long as the insurance company charges interest on the loan principal. And typically the insurer charges only a nominal interest rate, like 2%. Where else can you get a 2% loan interest rate?
But the best part for long-term planning is that policy loans from life insurance policies are not required to be paid back. Yes, you read that last sentence correctly: you don’t have to repay the loan on your policy. All that happens if you don’t repay the policy loan is that when the insured dies, the amount of death benefit that the insurer pays to the beneficiary of the policy will be reduced by the amount of the outstanding loan balance, including the interest due. What does that mean for long-term planning? It means that if you structure your policy correctly, you can use the cash in your policy to supplement your retirement income without having to ever pay a penny of income tax on that money. Savvy investors often buy large life insurance policies specifically to accumulate vast sums of cash to spend later in retirement without having to pay any taxes. (Please consult with an appropriate tax and/or legal professional to determine your specific situation.)
The bottom line is that you can use the special tax benefits of life insurance to finance large purchases as well as provide supplemental retirement income, all while saving taxes. And if there is any money left in your policy when you die, your designated beneficiary can receive the remainder of the policy without tax liability. (Again, please consult your tax professional for guidance for your particular situation.)
For further information on this concept or other insurance planning strategies, please contact Scott Semel, LUTCF (CA Lic# 0C67540), at 818-538-9321, ssemel@yahoo.com or www.scottsemel.droppages.com.
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