There was a 15-year period when I was working internationally, and I lost track of some of the things going on in the domestic life insurance market. When I “came back” to America, a producer said to me, “LIRPs are great for folks wishing to boost their tax-efficient future income.” I stared blankly at her while, in my head, quickly sorting through about a thousand life insurance industry acronyms. GRAT…CRUT…. SERP….PPLI. “LIRP” wasn’t there.
I had nothing and was regretting spending all my free time in Dubai eating dates and drinking carrot juice and missing out on advancements in the U.S. life insurance market. Only, I had not missed a thing. A LIRP is a life insurance retirement plan and imagine my surprise when I realized it was just a fancy name for maximum funding a life insurance policy. Kudos to the industry, though, for assigning an acronym!
Maximum funding a life insurance policy is a technique 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. It isn’t an emotional sale as is the case to buy life insurance to support a widow and children. The math works if the tax savings of the inside build-up and loans outweigh the insurance and other policy costs.
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.
A LIRP can perform a lot better than other investments at the same rate of return but only if a slew of requirements is met. First, the policy needs to be a non-Modified Endowment Contract (“non-MEC”) in order to allow future cash value loans to be tax-free. A loan taken from a life insurance policy that is not classified as a modified endowment contract under IRC §7702A is not includable in income because it is not treated as a distribution under IRC §72.
A non-MEC can typically be funded in as little as four, annual premium payments; though, the more premium payments made, the probability of stronger cash value growth increases. (To learn more about MECs and non-MECs, click here.)
Next, the owner of a LIRP should not expect to access the policy’s cash values for at least 10 years if not 15 or 20 years. In order to maintain the definition of life insurance and not be deemed an investment contract, the pure life insurance costs are much higher in the early years of the policy. Depending upon age, sex and health, the insurance costs drop to nearly negligible amounts after as little as seven years. At that point, the cash value growth is maximized and the benefits of a LIRP begin to take shape. If someone cannot commit to a lengthy time horizon to realize the advantages of a LIRP, they are better off putting their money elsewhere.
Another caveat is that the cash value policy loans only remain tax-free if the policy stays in-force until the death of the insured. If the policy lapses or is surrendered, then there will be taxation at ordinary income-tax rates. Yikes! If that happens, you can bet the LIRP was not the best route to take. Conversely, if the policy remains in-force, there will be a residual death benefit to heirs which is tax-free under IRC §101(a).
Finally, the age and health of the insured can make all the difference from making a LIRP perform exceptionally well, to doing just fine or just not being worth it. This brings us back to the math element. Older ages mean higher insurance costs and a potential for a shorter time horizon and either of those characteristics separately will impact viability. From a health perspective, clients with hefty health ratings assessed to their policies by underwriters may see insurance costs which overwhelm decent policy performance.
The last few paragraphs can be summed up by saying if someone is not too old, relatively healthy, can commit for (probably) at least 15 years and can make annual premium payments for a number of years, then a LIRP will likely look fantastic. As a supplemental retirement income strategy, it would make sense to market LIRPs to those in their 30s, 40s and early 50s who have maximized their qualified plans and have excess capital to contribute toward their future.
What are the life insurance products favored for LIRPs? Before I went abroad, there was a variable craze where VUL became all the rage. This is where the idea of maximum funding a life insurance policy really took off, especially where 12% rates of return were being illustrated. What happened at the end of the 90s was that these policyowners were seeing negative 12% returns so policies with some safeguards in place became more consumer-friendly for LIRPs.
Whole life and universal life contracts provided, for some time, decent dividend and crediting rates along with guaranteed floors of 4% or more. While not as attractive as the mega returns possible with VUL, whole life and universal life do not have the potential for mega losses, either.
While I was away, a policy type which took off was Indexed Universal Life (IUL) and provided some greater potential for cash value growth via linking performance to a market index. Most IULs also protect against performance losses and make this possible by capping the upside performance. IUL is not the easiest type of policy to understand but if properly serviced and the policyholder can stay on top of it, an IUL may be a good candidate for a LIRP. (To learn more about IUL, click here.)
By the way, IUL did catch up to me in Hong Kong in 2007 where it quickly became popular for premium loan financing. I read my first IUL policy specimen not over carrot juice but, rather, a $22 vodka martini at the Mandarin Oriental’s Captain’s Bar. That’s a subject for another time!
Read our companion Tier One Interview with Andrea Dykes by clicking here.
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.