What It Is and Why a New Law Has Made It Better
Perhaps no wealth planning tool is as strongly debated as permanent life insurance. On the one hand, permanent life insurance plays a major planning role for many individuals and businesses—from successful physicians, attorneys, and corporate executives to the country’s wealthiest families, leading banks, and Fortune 1000 companies. On the other hand, innumerable commentators and advisors in the media deride permanent insurance as a poor investment.
In this article, we will explain what permanent insurance is and how a federal statute passed in the last days of 2020 may have made it better.
What Is Permanent Life Insurance?
Before we explain what permanent insurance is and is not, let’s examine the alternative life insurance offering, term insurance.
Term insurance policies offer pure death benefit protection. They carry no cash value and provide protection for a limited period of time (referred to as a term). This limited time frame is usually ten to twenty years, though some companies offer a thirty-year term product. A term life insurance policy pays a specific lump sum to your designated beneficiary upon your death, so it can play an important role in providing temporary death protection for your family (or your practice or partners as part of a buy-sell arrangement).
Permanent Life Insurance
The category of permanent life insurance comprises products that, unlike term, carry cash values along with death benefits and can last for the entirety of the insured’s life—to age 100, 115, or beyond. (Of course, these products are “permanent” only as long as the required premiums are paid on time.)
While there are several different products in the general category of permanent insurance, all permanent policies enjoy tax-free growth of cash value and, if properly managed, access to the cash value tax-free. These tax benefits, along with asset protection in many states, is what attracts many to permanent insurance.
While there are more than five major categories of permanent life insurance, we will describe two of the more common types below. For more depth on this topic, see Lesson 4 of Wealth Planning for the Modern Physician: Residency to Retirement.
- Whole Life Insurance
Whole life (WL) insurance pays a death benefit to the beneficiary you name and offers you a cash value account with tax-deferred cash accumulation.
Pros: WL has a savings element (cash value) that is tax deferred. The cash value grows based on the life insurance company paying a dividend. This dividend is determined by the life insurance company, is not guaranteed, and is likely to change annually. Because of the low-interest-rate environment over the last fifteen years, dividend rates on whole life policies have been decreasing.You can borrow from this account free of income tax, or, if it is properly structured, you can cash in the policy during your lifetime. It has a fixed premium that can’t increase during your lifetime (as long as you pay the planned amount), and your premium is invested for you long term. Because it has the cash accumulation component, whole life insurance can offer benefits such as tax reduction, wealth accumulation, asset protection, estate planning, and tax diversification of asset classes.
Cons: WL does not allow you to invest in separate accounts (e.g., money market, stock, and bond funds). Thus, your policy’s returns will be tied to the life insurance company’s dividend credit based on that insurance company’s underlying investments. It also does not allow you to split your money among different accounts or to move your money between accounts, and it does not allow premium flexibility or face amount (death benefit amount) flexibility.
- Equity-Indexed Universal Life Insurance
Equity-indexed universal life insurance (EIUL) is a universal life policy (which has more premium and policy flexibility than a WL product) that allows you to select from a list of stock market indices to grow your cash value. If the investments fail, there is a guaranteed minimum death benefit paid to your beneficiary upon your death.EIUL gives you more upside than a traditional universal life policy because the insurance company contractually agrees to credit the policy’s cash value with the same return as the stock market index the policy holder chooses (typically, the S&P 500 Index, but it can be the Dow, NASDAQ or others) realized over the same period of time, subject to a cap and a floor. Thus, the policy owner has the upside of the indices (up to the cap) but the risk of the same indices (but only to the floor). Typical floors for an annual return begin at near 0% (no loss of principal), with caps around 10%.
Pros: EIUL enables you to get potentially more upside in the cash value accounts than WL but also gives you downside protection.
Cons: Products are relatively complex, with many choices of indices, participation rates, floors, and caps, and they vary significantly from insurance carrier to insurance carrier. Working with a professional who can help you make good decisions about policy placement and annual management is essential.
Is Permanent Life Insurance a “Good” Investment?
When thinking about permanent life insurance, many want to understand whether it is a “good” or “bad” investment. However, this question rests on a faulty assumption: How can permanent life insurance be a “good” or “bad” investment when the choices within permanent products are so broad and deep? In other words, the structure of a permanent life insurance policy allows for an almost limitless number of underlying investments within the structure—and those investments will provide the policy’s returns.
As we explained, WL offers a bond-based, dividends-type return. Is this good or bad? It depends on what the rest of the market does, doesn’t it? In 2008–09, an asset with such a return would likely have been the best-performing asset class on an investor’s balance sheet. For EIUL, the performance of the policy is based on the owner’s choice of indices – which could work out extremely well… or not.
The fact is, a permanent life policy can be a fantastic, great, good, fair, or poor investment because it isn’t an investment itself; rather, it’s a structure that houses investments, the choices of which are almost innumerable.
New Law Passed at the End of 2020 Improves Permanent Life Insurance
In the last week of 2020, the Consolidated Appropriations Act, 2021 was adopted. This statute included revisions to tax code Section 7702, which covers what the federal government considers to be a legitimate life insurance contract and impacts the pricing, structuring and taxation of permanent life insurance policies.
Suffice it say here that the new law will make permanent life insurance policies more attractive, by allowing policyholders to have more funds grow tax-free than have been allowed under recent rules. Thus, for investors attracted to this asset class for its tax-free growth and access, the new statute is a welcome one. Expect to hear more about this, as insurance companies restructure their products in response to the new law.
Permanent insurance, while often misunderstood, has significant tax benefits, which have only been improved by new law. To learn more, contact David Mandell or schedule a complimentary consultation with a member of the OJM team.