Richard L. Harris: It’s All About Income Tax

It’s All About Income Tax
Private placement life insurance may provide many advantages for your clients

by Richard L. Harris

Advisors build relationships with their clients by showing that they care. Bringing an idea to the client, whether the client decides to use it or not, is one way of accomplishing that goal. Even if the client isn’t interested, the conversation may lead to other opportunities. With new tax rates and the Medicare tax, income tax planning has become as important an issue as transfer taxes when doing estate planning. Life insurance has certain income tax benefits, and it can be used to provide advantages to wealthy clients. Here are some ideas to consider.

High Tax Bills
By now, your clients have received all the reports on their investments, including their K-1s for 2013. They may also have gotten sticker shock when they were told about their tax bills. For investments, the top ordinary income tax bracket is 39.6 percent, up from 35 percent in 2012. The long-term capital gains (LTCG) and qualified dividend tax rate is 20 percent, up from 15 percent in 2012. Adding in the 3.8 percent “Medicare” tax raises those rates to 43.4 percent (unearned ordinary income) and 23.8 percent (LTCG and qualified dividends). Compared with the 2012 tax rates, the tax on unearned ordinary income increased by 24 percent, and the tax on LTCG and dividends increased by 59 percent. Those increases don’t account for any state and local income taxes.

What’s a great way to shelter all that income and never pay income tax? Roth individual retirement accounts. But, Roth IRAs limit your client’s ability to contribute and the amount he can contribute. If your client is willing to pay income taxes on IRA assets now (if he has IRA assets), he can roll them over into a Roth. But, unless the time horizon is long enough and the return is high enough, converting to a Roth may not make sense.

Alternative Plan
There’s an alternative: a plan that looks like an unlimited Roth. It has the following features:

  • Contributions are in the millions;
  • If properly structured, money can be accessed without paying:
  • pre-59 1/2 10 percent penalty;
  • income tax;
  • No income tax at death, regardless of structure;
  • Allowed by the Internal Revenue Code;
  • Annualized cost approximately 1 percent of assets decreasing over time and by amount.

That “unlimited Roth IRA” is private placement life insurance (PPLI). When looking at the investment income tax rates, the story becomes compelling.

If you have any questions about the legitimacy of PPLI, please know it follows the same tax rules, set forth in IRC Section 7702, as commercial policies, such as variable universal life (VUL). With VUL, the owner of the policy has the ability to choose from numerous investment options called “separate accounts.” The carrier limits the amount the owner can pay in premiums. These separate accounts are insurance dedicated funds (IDFs) that are specific to VUL policies. The same companies that manage mutual funds also manage these separate accounts.

PPLI differs from VUL in the costs, surrender and investment options. Retail VUL products have high up-front costs associated with them. Commissions are the major up-front expense. Because of those costs, the policies have surrender charges. While your client’s gains or losses are calculated on the full value of his payment, less administrative and cost of insurance expenses, if your client surrenders the policy during the period that surrender charges are applicable (generally 10 years or longer), the charge will be deducted from the account value. PPLI has no surrender charges. The remuneration to the producer and the carrier charges are measured in basis points. Even including the cost of insurance, the annualized total cost is about 1 percent.

So far, PPLI sounds just like a wholesale product. Its investment choices are what make it different. Money managers and hedge funds that aren’t available in commercial VUL (and some that are) comprise the investment choices. Because of the investment choices, manager minimums and insurance company rules, the minimum premiums are high (generally, at least $2 million paid in over four or five years). PPLI is only available to accredited investors.

If your client is concerned about the credit worthiness of the insurance company, he should note the assets only technically belong to the insurance company as a separate account. That is, separate accounts are assets held by the insurance company, but they’re not available to the insurance company’s creditors. The life insurance itself has some creditor protection. Many states have laws that protect some or all of the life insurance death benefit and/or cash surrender value from the policy owner’s creditors. The policy owner can surrender the policy at any time.

Factors to Consider
Why aren’t wealthy people beating down the doors of the PPLI companies? Because it doesn’t work for everyone. Here are some factors your clients should consider to determine if PPLI is the right strategy for them.

Taxable income generated. The first and major consideration is the tax benefit. Does the investment choice generate enough taxable income to be worth the 1 percent annual charge on assets? For example, if your client has $10 million to invest, will the cost of taxes exceed $100,000, the asset charge in PPLI? If the investment (such as bonds or hedge funds that have frequent turnover) generates more than $229,000 of ordinary income (2.29 percent), the tax will be more than $100,000. If the investment generates more than $420,000 of capital gains (4.20 percent), the tax will be more than $100,000. Any combination of ordinary income and capital gains will fall between the two numbers. State and local taxes lower the threshold.

Client as insured. Because PPLI is life insurance, the client may have an issue with being the insured. But, as long as he’s the owner of the policy, another family member can be the insured, and the owner can still enjoy the tax benefits.

Investment choices. Are the investment choices already available suitable for the client, or does the client have a relationship with a money manager or hedge fund that he would like to use instead? A number of trust companies, hedge funds, money management firms and large investment organizations already offer separate accounts under PPLI. For example, Goldman Sachs has numerous IDFs available in PPLI products. While there are a large number of PPLI separate accounts to choose from, many people want one tailored for them.

If the client wants someone who isn’t already available in the PPLI product to manage the investments, he must address additional issues. In most cases, he must create an IDF, which can usually be accomplished in a short period of time at nominal cost. In an IDF, the manager will have to report fund values to the insurance company on a quarterly basis. The IDF account must have five or more separate underlying assets to be considered diversified. The investor can’t control the choice of the underlying assets the manager uses. For example, in an IDF from a mutual fund company, your client decides whether to invest in the fund but doesn’t decide what the fund manager invests in.

Willing money manager. An additional barrier may be the money manager the client would like to use. Will that money manager be willing to set up an IDF to invest through PPLI? Some managers just won’t do it as a matter of policy or because of what needs to take place. To do this technique with money already with the manager, the investment needs to be liquidated before going into PPLI as cash premium. Managers may be concerned that when the investment is liquidated, the client may think twice about reinvesting with them. (Any income taxes that result from the liquidation needs to be factored into the client’s decision.) But in many cases, a large enough investment will stimulate the manager to go ahead. Enlightened money managers that have tax-inefficient funds offer their clients both options—a direct investment (especially for non-tax paying entities) and the ability to invest through PPLI for those who do have tax considerations. Offering options gives money managers a competitive advantage over their peers who don’t offer PPLI options.

As an alternative to PPLI, a client may want to invest in a private placement variable annuity (PPVA). PPVA defers income tax, unlike PPLI, which can avoid it. It’s subject to the same rules described above for PPLI. It’s also subject to the same rules as commercially available annuities. Any distribution is taxed as ordinary income. Unless annuitized, the gain comes out before basis. Pre-age 591/2 withdrawals of gain are subject to a 10 percent penalty. At death, to the extent there’s an estate tax owed, the annuity is income with respect to a decedent. Regardless, the income tax deferral ends. There’s no underwriting with a PPVA. A simple application is completed, and money is transferred to the insurance company.

The other features and requirements are the same as PPLI, except the cost. Because there’s no life insurance death benefit component, there are no costs of insurance taken out each month. Consequently the expenses connected with a PPVA are lower than PPLI.

Even though PPVA is only a deferral technique, it’s still very valuable. If the underlying investment were to be taxed as ordinary income, the benefit of deferring the taxes is worthwhile. If one does the math, not having to pay income tax on an ongoing basis and only paying at the end will produce a larger net amount for the owner or beneficiaries. (Modeling should be done to determine the benefit.) Family offices are using both PPLI and PPVA. When they use PPVA, they often choose a very young family member as the annuitant. That way, the tax deferral period is maximized.

Implementing the Strategy
Let’s assume that your client is interested in investments inside private placement products or that he personally has assets that produce enough taxable income to get over the efficiency hurdle. The client may have an existing money manager who’s willing to work inside an IDF, or the client can find a manager with a strategy and performance history the client likes, and that manager is already in or is willing to work as an IDF. At that time, implementation should begin. Because this is an insurance product, your client needs to involve an insurance broker. However, most life insurance agents and brokers are unfamiliar with private placement products. Your client should only use a broker knowledgeable and experienced in this field.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s