Why HNW Clients Should Explore Whole Life Insurance

Wealthy individuals need a tax efficient way to stash more retirement savings. These policies can help them and their heirs.

Dmitriy Yankelevich
Dmitriy Yankelevich

Helping high-net-worth individuals put away more money tax efficiently for retirement is challenging. Roth IRA contributions phase out at annual incomes of $144,000 for individuals, $214,000 for married people filing jointly. Maximum IRA contributions aren’t anything to get excited about either ($6,000, or $7,000 for those 50 and over).

Many experts also expect to see tax-rate hikes across the board for the highest earners. Participating and funding a structure that has little or no taxable consequences to clients’ assets is an extremely attractive proposition and is driving interest in whole life insurance.

Although this article will focus on whole life insurance, plain life insurance is also experiencing greater interest from a cross section of America.

Whole life is a kind of permanent life insurance, which comes in many forms. What permanent life policies have in common is they last for the lifetime of the insured as long as premiums are paid. They also offer a death benefit and a savings component, called cash value. Whole life, for example, grows cash value from dividends the company pays on the policy. Universal life grows cash value based on applied interest rates. The cash value of variable universal life increases or decreases based on investment performance. With permanent life insurance, the policyholder can often borrow against or withdraw the cash value.

These policies can be set up in a variety of different ways when it comes to beneficiaries. For example, some only pay a death benefit to the beneficiaries (any remaining cash value goes to the insurance company). Other policies include riders (for an additional cost) that provide a death benefit and accumulated cash values for beneficiaries.

Putting whole life to work

We use whole life policies as a way to help clients contribute post-tax dollars into tax-efficient vehicles.

Although we’re in a relatively moderate to low tax environment, we can’t forget how high rates have been historically. The individual capital gains tax rate rose from 12.5% in the 1920s to as high as 35% in the 1970s; today’s top rate is 20%. The maximum tax rate on dividends (which are taxed as income) hit 79% in the 1930s, edged even higher mid-century before falling to 50% in the 1980s, and is now 15%. The maximum marginal income tax rate rose to 63% during the Great Depression and spiraled to 92% in the 1950s before tax cuts were enacted. The top rate, currently 37%, has hovered between 35% and 40% for the past 35 years. Many experts agree we may be in for a rise in all three of these tax categories.

Life insurance policies are governed by IRS Tax Code 7702, which grants tax-free status not only to death benefits but also to cash values. Thus, it is possible for the policyowner to access this “surplus” cash in the future tax free through withdrawals and/or loans from the policy.

Obviously, a lot of strict rules and regulations prevent people from abusing these favorable rules. Owners can also be left to foot the tax bill if the IRS strips favorable tax treatment from the policies, which has happened. Individuals considering using these policies as tax-efficient vehicles must learn the rules. Working with a licensed professional can help set them up and maintain these policies throughout the years.

Is it appropriate?

There are a multitude of factors that would contribute to the final decision about whether a whole life policy is an appropriate vehicle for your client. At the end of the day, if I could oversimplify the approach, the key question is the following:  What is more painful for the client — paying taxes or paying the cost of insurance?

If the cost of insurance is 10 cents on the dollar, and client can save 35 cents on the dollar in taxes, then it is more advantageous for the client to engage in this strategy. Starting age plays a significant role, too. Typically, the younger the owner, the cheaper the cost of insurance. A younger client also has a longer time horizon to allow money to grow and compound more.

On the other hand, younger clients usually do not earn as much, limiting the overall wealth that could be created through these strategies.

Health-exam caveat

The whole-life-insurance strategy is limited by the health “entrance exam” for candidates that do not have pre-existing health conditions. Folks with pre-existing health conditions would unfortunately be denied access to these tax-advantaged vehicles, which may eliminate many of your older clients.

It could also make sense for some of your client’s children to secure such coverage at a younger age in case certain health conditions develop over the years. (Does heart disease run in the family?) Illnesses developed later in life could preclude them from obtaining such coverage. Younger clients can also obtain term life insurance (cheaper coverage), with the intention to convert it into whole life coverage later, without having to go through any medical underwriting.

Your client’s children may be more interested in life insurance than you think. In a 2001 survey from LIMRA and A Better Way, 45% of millennials said they are more likely to buy life insurance because of COVID-19. They have more years of income to protect, are more likely to have children, and may still have large balances on their mortgages or even student loans.

Custom-size the contribution

For individuals who qualify for whole life insurance, their annual contribution amount can be custom-sized — with practically no limit — based on the size of the policy. This is good for HNW clients who are restricted by the universal limits that govern IRA and 401(k) plan contribution limits.

The IRS does impose modified endowment contract (MEC) rules on these policies, essentially limiting the amount of money an individual can contribute annually under these contracts. However, unlike IRAs and 401(k)s, this limit is not universal. Instead, it is based on 1) the age and gender of the insured, 2) the health rating of the insured, and, most important, 3) the size of the policy. The larger the policy, the larger the allowed annual premium for the insured.

For example, an affluent male client aged 45 with annual income of $950,000 has already maxed out his 401(k) contributions for the year at $20,500. He wants to put away money on a post-tax basis and not pay any dividend reinvestment tax, capital gains tax, or income tax upon distribution. Since he is phased out of Roth IRA contributions (because of his income), we suggested he apply for a whole life policy. Because he was in good health, he qualified for a top health rating, and now is able to contribute $60,740 per year into his $3,000,000 whole life policy.

No market correlation

Another advantage of dividend-driven whole life policies is that, historically, dividends from insurance companies have very little or no correlation to stock-market fluctuations. Using these assets during retirement, in conjunction with traditional assets, creates a much more successful income stream that often results in leftover assets for the policyholder’s beneficiaries.

When we review the historical rates of dividends paid by mutual life insurance companies throughout different financial crises (market crash of 1987, tech bubble burst of 2000, housing market crash of 2008-2009, COVID pandemic in 2020), it becomes evident that investors’ assets held in dividend-based funds do not shrink in value.

If retirees are living off their IRA and/or 401(k) plan funds that are invested in the market, a sharp downturn can adversely affect the values of these portfolios. During a market downturn, the retirees could switch and make withdrawals from the cash values of their whole life policy, which is unaffected by the market activity. They can then leave their funds in their IRA and 401(k) portfolios to recover after the market crash, without further stressing them by making a withdrawal. This would significantly improve the longevity and overall left-over values of the IRA/401(k) portfolios.

Additional Reading: How to Educate Clients About Annuities 

Offset taxable income

The majority of retirement income streams are taxable, including Social Security, pensions, and traditional IRAs and 401(k)s (which are all taxable as income); rental income; and investment income (taxable as capital gains). It is very important to create an offset to this unfavorable tax treatment of our retirement money with tax-free income, like Roth structures and/or whole life policies.

As an overly simplified example, let’s say a retiree’s annual income need is $100,000. If he or she receives $36,000 from Social Security and supplements it with a $64,000 withdrawal from a traditional IRA or 401(k) plan, the retiree would have to deal with taxable income of almost $100,000. Conversely, if half of the desired income comes from a Roth IRA or a whole life policy, then the retiree would only realize about $50,000 of taxable income for the year.

Don’t let clients too easily dismiss whole life insurance or jump into it readily. As their advisor, you can be a guide and help them find the information they need to make the best decisions for their unique situation.

Dmitriy Yankelevich, CFP, is a member of the Barnum Financial Group and is based in New York City. He can be reached at DYankelevich@barnumfg.com.



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