Life Insurance Retirement Planning, or LIRP, has become a popular tool for diversifying your supplemental retirement income plan to potentially reduce taxes.
There are many common objections (mostly found online) of using Indexed Universal Life Insurance (IUL) as a Tax-Free retirement income and estate plan. Most of the time when we discuss using LIRPs as a smart way of protecting assets, staying insured and planning for retirement income, the first thing many people do is some research online. In the cases that these make sense, there is a need for the life insurance and limiting risks, and diversifying future income to reduce taxes is a primary goal.
Here are some commons objections and listed disadvantages of using this strategy and our response to those comments and articles. It has many names online including LIRP, IUL, Infinite Banking, Becoming Your Own Bank, etc. These all mean roughly the same thing.
1. Taxation of the IUL and not receiving a current year tax deduction for the contributions or premiums paid. IUL policies are life insurance policies, which have generally received favorable tax treatment from Congress. There is no tax deduction on premiums paid. But the cash value of the policy grows tax-deferred, and the policy owner can generally access the cash value of the policy tax-free at any time, provided the policy remains in force. Since there is no income tax or capital gains tax on the proceeds of withdrawals or loans against in force policies, and since there is no 10% penalty on proceeds received prior to age 59 1/2, IUL policies have become popular savings vehicles for some individuals, especially those who earn too much to qualify for retirement accounts, such as Roths IRAs, or who have maximized allowable contributions.
Response: There is a prevailing line of reasoning among some online “gurus” that we should only be contributing to tax-free accounts once we have maxed out all our other tax-deferred accounts. This, of course, runs counter to everything we believe (and that math suggests) if tax rates in the future are likely to be higher than they are today. See some of our other articles for more information on future tax rates.
2. Policy premiums can be higher than the guaranteed rate of return. Equity indexed universal life policies have favorable tax treatment, no restrictions on what the cash value can be used for, and provide a potential tax-free cash death benefit for the policy beneficiary in the event of the death of the insured. Additionally, the cash value in an IUL policy generally receives some creditor protection, depending on the state, and does not count against the family for the purposes of determining need-based financial aid for college. Finally, IUL policies do provide some safety of capital, because the policy owner is guaranteed a minimum crediting rating. However, policy premiums are frequently higher than the guaranteed rate, especially on low-balance cash values.
Response: Many IUL’s provide a guaranteed rate of return of around 2-3%. This means that if your account value doesn’t grow at least 2-3% per year over a period of time (in some cases 8 -10 years), the company will go back and retroactively credit 2-3% for each of those years. I can’t conceive of a scenario where a company would ever have to actually honor this guarantee. With certain companies, there has never been any 8 year period over a 30 year history that has averaged less than 6%. So, I think this comment may be a case of “let’s be sure to disclose every possible thing that could go wrong.”
3. IUL's have a high fee structure and surrender charges that can result in a lapse later in life. IUL policies can have a relatively high fee structure compared with competing savings vehicles. Commissions are front-loaded, so it can take years before the cash surrender value of the policy catches up with the accumulated premiums paid into the policy. Unless the policy is aggressively funded, the cash value is frequently insufficient to keep the policy in force later in life, and many times retirees are faced with the unpleasant choice of letting a policy lapse or paying amounts of premium to keep the policy alive. Finally, the crediting methods the companies use to calculate the policy owner’s share of stock market returns frequently lead to disappointing results. Caps on returns are generally lower than the historic performance of the stock market. The company keeps the rest.
Response: Certainly the policy needs to be aggressively funded and this is what we have suggested in almost all cases. The key is to always buy as little insurance as the IRS requires of us, while stuffing as much money into it as the IRS allows. We’re attempting to re-engineer a life insurance policy to mimic a Roth IRA, only without the contribution limits and income limitations. In order to do so, expenses need to be as low, if not lower, than what you might find in a typical managed Roth IRA. The math suggests that we have done so in our suggestions. If you can get possible Long Term Care benefits, life insurance benefits and a guarantee you’ll never lose money in exchange for those expenses, then you’re already ahead of where the Roth gets you. In many scenarios, we have found the total costs to be 1.5 - 2% of the account values over the life of the plan, but at least you are getting something other than advice for those costs, such as the death benefit to your family.
4. Costs of insurance can be changed. The cost of insurance is separate from the cash values. This allows the insurance company to raise the cost of insurance and make the policy more expensive to own. This is problematic with all universal life insurance. However, indexed life insurance has a particular kind of risk associated with it that could make it extremely susceptible to higher cost of insurance charges in the future. Since interest is credited using index call options, the insurance company needs to make sure it is fully hedged (that it has enough call options to pay the promised interest rate in the contract). However, insurance companies are not mandated to be fully hedged. If an insurance company does not purchase enough call options to cover its liabilities, it may need to raise the cost of insurance to raise money to pay future claims.
Response: Most companies handle the fluctuating cost of options by raising and lowering caps. The cost of the option to cover the index usually goes up when the market is volatile, i.e., 2008. In 2008, when the world was coming apart at the seams, one of the company we use lowered their cap from 15% to just 14.5% and it has stayed steady ever since. This is just one example.
5. Not enough history of IUL's to gather data. There is simply not a long history with index life insurance. Modern index life policy design began in the early to mid-1990s. As such, it is simply unknown as to how well these products will perform over very long periods of time through repeated bull and bear market cycles (i.e., 50+ years).
Response: They do have back-tested historical returns that go as far back 30 years. These demonstrate how the program would have performed, in real numbers, had it been in place over longer periods of time. These can be ran with your exact scenario to compare to the proposed plans and rates.
6. Possible Bond like returns over time. Index universal life provides for an index-linked interest credit at the end of each crediting period with the guarantee that the interest credit can never be negative. This is a very attractive feature. But remember that carriers invest the vast majority of their index universal life premiums in bonds. This means that clients can expect, over a long period of time, for the average return on their index universal life product to be in the same range as bond returns. To clients who strongly believe that stock returns will soundly beat bond returns over time, this is a disadvantage of index universal life.
Response: This statement would be made about a company that did not specialize in IUL's, LIRP, or an advisor that was not experienced in setting up the correct plan. Many of the top companies that specialize in these products have index allocation options that historically trump "bond-like" returns. One strategy that we use in particular has a back-tested index average of 7.87% after taxes over the past 25 years! This outperforms even the stock market with no losing years, grows tax-deferred, and is readily accessible. There are several other options that we use that range anywhere from 6.4% to 9.2% as well.
7. Illustrations are unreliable. Index universal life is often sold as a retirement savings vehicle through the use of an illustration that shows premiums for a period of years, followed by a series of contract loans over the retirement period. It is not unusual for such illustrations to show values 20 years, 40 years or even more years in the future. Keep in mind, however, that the underlying index return may differ greatly from the assumptions used in creating the illustration.
Response: This is true. Illustrations are not "real life". They are run on an indexed average and should be run again at least every 5 years minimum while the contract is in place to keep an eye on what the real returns have been. Many inexperienced producers will illustrate above average rates of return to make the retirement income look better than what may actually happen. This is a mistake and could result in dire consequences for the consumer. As we mention often, there is a difference between Actual and Average rates of return. If people say the stock market averages 8%, the actual return could have been more like 6.5%. Therefore, you cannot have an Illustration showing 8% returns every year for 40 years or you will end up highly disappointed.
Conclusion: You can find good and bad on everything on the internet if you look hard enough. In an attempt to cut through all the static, we put an enormous emphasis on the math behind our recommendations. If the math suggests that these types of programs will push you further ahead of where you might otherwise be, help diversify your assets for tax purposes, protect your estate from premature death and Long Term Care risks, then it could be a welcome compliment to what you’ve already done. We welcome any other questions that may arise as you further research our recommendations. Visit our Contact Us page for a complimentary strategy session to see if and how LIRP planning could help your retirement income.
"The Power of Zero" David McKnight "Tax-Free Retirement" Patrick Kelly
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