Tax Free Legacy Planning

Last week’s episode about legacy planning with enhanced death benefits on annuities left out one critical detail and I’m surprised no one mentioned it.  Death benefits on life insurance are tax free but not annuities.  Any enhanced benefit with annuities is additional taxable income to the beneficiary.  That’s a big reason why many beneficiaries might not exercise the enhanced benefit.  It takes five years to get it so the time value of money reduces the real value and taxes degrade it even further.  Annuities are a last resort to offer some additional benefit but are not the bedrock of tax free legacy planning.

That’s what life insurance does best.  Before you turn away I suggest you keep an open mind and hear me out for at least a few paragraphs.  Whole life insurance is the oldest and most stable financial asset to ever exist.  Those who don’t like it truly don’t understand it.  If you are in serious debt then go ahead and listen to Dave Ramsey.  If you’re flat broke then take Suze Orman’s advice.  I’m not talking to the same crowd as they are so we’re going to take the road less traveled and work on understanding more serious financial concepts.

Over the years of running this website I have met people at all levels of retirement planning.  From those who are starting to save late to those who are completely set from every angle imaginable.  I know something about impregnable retirement plans because I’ve seen several and my early years in the business were spent learning how the richest people make it happen.  The most financially stable people I’ve met from the website all have one thing in common.  They all have a substantial portion of their assets in tax-free cash within whole life insurance policies.

This is not a coincidence.  You can do a little digging and find that many of the wealthiest families and corporations use whole life insurance as the foundation for generational wealth.  Many hundreds of the largest executives in corporate America have negotiated life insurance policies as a major part of deferred compensation packages and individual pension plans.  Sports fans might recall Jim Harbaugh’s compensation package as the Michigan head football coach.  As part of it, the school agreed to start a life insurance policy with $4M and pay an additional $2M for each of the following five years.  Do I have your attention yet?  It’s not a small-time deal and stupid people aren’t the ones doing it as Ramsey and Orman might suggest.

This is something I should have hit before because I get several requests every year.  You don’t need millions of dollars to take advantage of the tax free legacy planning benefits and I got a request for something like this just last week.  While I was working on the podcast for Annuity Death Benefits, this case fell in my lap so it makes sense to follow that one up with this.  The fundamental difference is taxable vs. tax free legacy planning and it was stupid of me to not mention it.  This is a correction as well as new content.

Here’s the deal, a 66 year old guy wanted to take $300K from his IRA and set it up for maximum legacy to leave his kids.  Life insurance has to be purchased with after-tax money so taxes would have to be paid first.  It’s a big part of the calculation so we have to get it right.  There are lots of people selling life insurance out there and most of it is a gimmick.  Focus on where the real money goes and follow that.  

Whole life insurance has been around for centuries and universal life has been around for about 40 years.  Whole life has a level cost of insurance for all years and universal life has annually renewable insurance premiums that increase each year you get older.  Universal life was created in the 80s when interest rates were really high.  As rates dropped, the internal cost of insurance rose and started to eat away all the cash value of the policy.  In the late 90s a majority of universal life policies lapsed because the cost of insurance got too high and dividends were much lower than initially projected.  What was sold as a cheaper alternative to whole life failed most people because rates didn’t hold up.  If universal life was fully funded then it worked just fine.  So why not just stick with whole life since it has worked for hundreds of years?

Enter Indexed Universal Life.  If returns could be increased above what fixed rates are paying then the policy will survive, right?  Just like indexed annuities, growth is not guaranteed but part of the market upside can be captured and it might pay off from time to time.  But that pesky increasing cost of insurance is something that hasn’t hit most of the early buyers of the product.  I’m not going to go into a lot of detail on this but there are far too many moving parts.  Just like the early version it needs to be overfunded to have a shot.  Some are doing it but many are not.  This is what most of the schmucks are selling these days but don’t be fooled.  If you’re going to spend the money then just buy a whole life policy.

Let’s get back to the case study…

If we take $300K from the IRA and fund the life insurance policy there are several ways to do it. In this type of case we need to test a lot of different scenarios to see what works best.  The easiest way to fund the life policy is by using a single premium immediate annuity (SPIA).  This person expects to pay taxes in the 22% bracket so the net of that can go into the policy.  I rounded the numbers to make it easy and it’s within a few dollars.  The three scenarios we start with are based on the cash flows below.

Net Proceeds from SPIA:

10 Year Period Certain- $30,000 annually

Annuity pays for 10 years only

$18,000 annual premium for insurance and $12,000 additional cash that goes straight into the policy cash value and death benefit 

15 Year Period Certain- $22,000 annually

Annuity pays for 15 years only

$18,000 annual premium for insurance and $4,000 additional cash that straight into the policy cash value and death benefit

Life w/ 15 Years Certain- $18,000 annually

Annuity pays for life with a minimum guarantee of 15 years, whichever is longer

Insurance premium only and the policy grows naturally.  Premium will offset roughly 15 years out but can be continued to maximize cash value and death benefit

If death occurs before the annuity payments stop, the death benefit is payable and remaining guaranteed annuity payments will also continue to the beneficiaries.

Each scenario turns out differently, depending on the specific mix of insurance premium and additional cash.  When cash is added the death benefit grows.  When dividends are paid the death benefit grows.  Every dollar that goes into the policy leverages greater tax-free accumulation and ultimately a tax free death benefit.  A deeper explanation of each illustration, along with the numbers, is in the podcast and on YouTube.

In the most aggressive scenario, payments are made for ten years.  Cash value is $266,000 and the death benefit has grown to more than $524,000.  No premiums are due after this and the cash value continues to grow on a tax free basis.  By looking at the illustration you’ll notice that the death benefit slightly declines for a few years until eventually growing again until the death benefit is paid out.  Once the cost of insurance is covered by the dividends the both cash value and death benefit will grow steadily.  Payments don’t have to stop but we illustrate it to fit in the budget we have.  Any time there is extra cash needing a use it can be put into the policy for tax free growth and an even larger death benefit.  In this situation there will be RMDs that may not be necessary for retirement expenses so this has the potential to be as good as he wants to make it.

Cash value is an important detail to discuss.  There are several options and it’s important to understand that the contract is 100% liquid at all times.  Borrowing from the policy will only reduce the death benefit by the amount taken and it’s a tax free distribution.  Additional details about how loans work is a subject all its own and can be done on a case by case basis.  Another way to access money is to have dividends paid in cash to create additional retirement income later in life.  It’s also tax free until distributions exceed total premiums paid.

The difference between guaranteed and net cash value is something that many people will notice.  Guaranteed is in the contract and net cash is based on that plus the current dividend rate from the company.  Since the top line is not guaranteed then this is where many people need to understand the real value in the contract.  This would be issued by a mutual company and that can not be understated.  Mutual companies are owned by the policyholders and all profits are equally shared on an annual basis.  There are no stockholders to appease or corporate bonuses to be paid and all company operations are conducted with the express purpose of maximizing benefits for policyholders.  When major mutual companies have a track record of paying dividends in excess of the guaranteed rates for more than 160 years in the case of Guardian Life.  Through the World Wars, the Great Depression, and every single economic disaster since the Industrial Age, these companies have delivered solid dividends well above the guarantee.

The transition everyone needs to make is to realize that you are buying an asset with an incredible amount of flexibility.  It is the most versatile and profitable way to leave a legacy and can be used for retirement income or serious estate planning at any level.  Every dollar that goes in creates value.  It’s a secret of the wealthy but available to everyone and the option to enhance retirement is well worth exploring.  My mentor in this business is one of the country’s best cash value insurance guys so this is not even an attempt for me to sell something.  I’ll refer every bit of business to him because I owe him something for all he has taught me.

If you want a solid referral to the most ethical and professional person I know then I’d be happy to make an introduction.

Have a great weekend…


Podcast Episode: Tax Free Legacy Planning

Listen to “Tax Free Legacy Planning” on Apple Podcast

Last Updated on March 8, 2024 by Bryan Anderson