Tier One: A Year in LIRP
In October of 2020, I wrote a blog about life insurance retirement plans (LIRPs) and how they are a tax-efficient strategy in meeting future income needs. It was widely read and drove an above-average amount of traffic to the LISG website. I was satisfied that I had covered another one of the basic applications of life insurance and moved on to the next month’s topic.
Well, our readers didn’t move on. The events of the next year led to an increase in popularity in both those who wanted to learn about LIRPs and those actually executing on the strategy. Our website SEO analytics have shown the LIRP blog to consistently be in the top three blogs read on our site. Further research told us that the term “LIRP” was being searched on Google like never before and that was contributing to our web traffic. So, what happened?
We will get to that in a moment. First, let’s recall that a LIRP is maximum funding a cash value life insurance policy where a policyholder purchases as little death benefit as permitted by law in order to keep the cost of insurance low and to maximize the tax-free inside build-up (growth) of the policy’s cash value.
At some point in the future, the policy’s cash value is accessed by the policyholder to take tax-free loans. Since the policy is the asset of the policyholder and they are taking a loan from something they own, loan rates are usually quite low and, in some situations, almost zero percent.
A LIRP falls neatly into the ‘math category’ of life insurance strategies. Either the math works, and the concept makes sense, or it doesn’t. In other words, the policyholder will compare a taxable investment, likely with capital gains treatment, at the same rate of return as the policy. If, because of the tax-free cash value growth and the tax-free loans, more money can come from the policy than the other investment, a LIRP is the way to go.
What happened in the past year to boost the popularity started in November of 2020 when President-elect Biden announced this tax plan and it looked like taxes were headed for the stars. This didn’t happen, at least not yet, but it was a wake-up call that higher taxes are likely inevitable. This led for a search on ways to reduce, defer and eliminate taxation. Once qualified plans are funded, a LIRP should be considered.
President Trump (or Congressman Neal) Helps
Next, right before 2020 ended, then President Trump signed into law the Consolidated Appropriations Act 2021 (the “Act”), a law to continue funding the federal government that included a change in the definition of life insurance. Specifically, the Act changed the minimum statutory interest rate assumptions used to calculate premium funding limits under IRC §§7702 and 7702(a) so that the rates for new policies are no longer fixed once a policy is in-force and are allowed to change as often as once a year. In addition, the starting fixed rates for new policies were increased. This provision of the Act was spearheaded by Congressman Richard Neal, who is a former MassMutual agent and represents Springfield, MA, where MassMutual is headquartered.
Why is this a big deal? Under most circumstances, policyholders of cash value life insurance policies will be able to place more premium into their policies, sometimes upward of three times as much or more. As a result, LIRPs generally became a lot more tax-efficient and the ‘math’ of tax savings versus life insurance costs became a lot more favorable due to the additional tax savings.
The trifecta in 2021 events was the start of an inflationary period in the U.S. and the perceived impact this continues to have on personal finances. Over time, inflation can reduce the value of one’s savings, so saving more is often a response. A LIRP, once again, is seemingly a perfect fit.
In my prior piece, I did not discuss the types of permanent life insurance products available and their suitability for a LIRP.
Permanent policies that have a cash value such as whole life, universal life, indexed universal life and variable universal life are popular contracts for use with LIRPs. Each has pros and cons potential LIRP participants should understand how each works and the risks involved.
Whole Life Insurance
Whole life policies have fixed premiums that guarantee coverage for life as long as the premiums are paid. This guarantee makes whole life generally more expensive than its universal life counterparts. Also, when whole life policies’ cash values are accessed for withdrawals and loans, the coverage guarantee is either shortened in length or eliminated. Cash value growth is determined by a dividend rate annually declared by the insurance company, meaning the LIRP owner does not shoulder any of the cash value investment risk.
Currently, whole life dividend rates are hovering in the 4% to 5% range. This is not fantastic but, remember, with a LIRP, the comparison is to a taxable account. In a LIRP, you would be receiving the dividend rate gross of insurance and policy costs, but you would then be accumulating cash value tax-free and accessing the policy via tax-free loans. Not bad.
Where I caution folks is that, in periods of rising interest rates – as during inflationary periods – life insurance companies generally lag far behind other financial sectors in raising rates to clients. This is because of the drag of insurers’ in-force policy portfolios. These portfolios are invested in conservative, low interest rate assets and it takes some time for insurers to take advantage of increasing interest rates and then to pass that onto policyholders.
Universal life differs from whole life in that it does not have fixed premiums and offers flexibility in the timing and amount of premiums paid. As long as there is sufficient cash value to meet policy expenses, a universal life contract will remain in-force. The cash value growth is determined by a crediting rate established by the insurance company. The crediting rate is generally guaranteed for a year and includes a minimum, guaranteed rate.
While the crediting rate is set by the insurance company, the owner of a universal life contract shares responsibility for the performance of the cash value by making sure to pay the premiums necessary to grow the policy’s cash values sufficiently to meet future income goals.
Given the current, historically low crediting rates for universal life contracts, I would not recommend using the contract for a LIRP. The ‘math’ would be tough, meaning the performance of the policy may not make the tax-saving worthwhile or just barely so.
Indexed Universal Life (IUL)
Indexed universal life is a type of universal life where instead of the insurance company setting a crediting rate upon which to base cash value growth, the policy owner is permitted to link policy performance to one or more indices, such as the S&P 500. This permits the policy owner the opportunity for greater cash value growth than with standard universal life or whole life. Most indexed universal life policies include a minimum guaranteed crediting rate, often 0%, which is off-set by performance ceilings, providing ‘guardrails’ to mitigate volatility which can negatively impact long-term performance.
I have mixed feelings about using IUL for a LIRP. On one hand, I like the idea of ‘guardrails’ so that a less sophisticated purchaser doesn’t have to worry about severe losses. Also, the use of indexes can permit better policy performance than from a whole or universal life contract.
On the other hand, over the past several months, we have seen insurers lower the top guardrail, or the caps on index performance. This means the upside is becoming less attractive, though, still attractive enough to generate sufficient tax efficiency for a LIRP.
Variable Universal Life (VUL)
Variable universal life works off the same premise as indexed universal life except the cash value is invested into popular funds chosen by the policy owner from a platform. Although some variable universal life policies allow the purchase of cash value performance and death benefit guarantees, many do not have restrictions to how much the cash value can grow or fall. Where a whole life policy owner has no cash value investment risk, much of that risk falls to the owner of a variable universal life contract.
If a LIRP user is willing to pay attention to their policy, then I am bullish on the use of VUL contract. A VUL policy allows a policyholder to more quickly take advantage of a rising interest rate environment as well as a large number of investment options on an insurer’s platform. Unlike the original ‘variable heydays’ of the last 1990s, many of today’s VUL contracts offer a variety of guarantees and fixed options, including index options found in IUL contracts.
What a consumer may encounter is a life insurance producer who does not have securities licenses and there is unable to sell VUL. Before working with your life insurance producer on determining if a LIRP is a fit, ask them if they can sell variable contracts. If so, you will be able to explore all the options available to you.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.