Life Insurance as an Investment Vehicle
Common uses of life insurance
Life insurance is primarily used as an asset that will provide a death benefit to the beneficiaries upon the death of the insured. Common designs of these policies are to minimize the amount paid for the desired level of death benefit, providing liquidity in situations where otherwise cash may be hard to come by to cover a certain expense or liability. Some of these situations include:
Estate tax liability—using life insurance (if one can qualify medically) can be the most efficient way to pay estate tax while avoiding a forced liquidation of assets.
Buy-sell or business succession planning—using life insurance can provide liquidity to buy out the shares/ownership interests of an heir to a deceased partner.
Key person insurance—using life insurance can help to replace the economic value of a key employee and/or provide the capital to recruit a replacement employee if they were to pass away.
Estate equalization—using life insurance can help replace assets that were donated to charities, or help equalize an estate if certain children are involved in a family business and others are not.
Term vs. permanent insurance
Depending on the objectives, term or permanent insurance may be appropriate. Term insurance is a use-it-or-lose-it scenario, where an owner pays a set premium for a fixed period of time. Therefore, the premiums act more like an expense. Permanent insurance can last for the lifetime of the policy holder, depending on how it is designed. While the premiums are higher in permanent products when compared to term insurance, the premiums are more than just expenses as they can be invested in the policy and create a cash value in the life insurance policy. This “cash accumulation” feature in permanent policies is often overlooked compared to the death benefit feature of insurance. As long as the policy is designed correctly and does not become a modified endowment contract (MEC), the cash feature inside of the policy can act similarly to a Roth IRA/401(k) as far as the tax treatment is concerned.
Permanent insurance vs. Roth IRA/401(k)
In permanent insurance products, after-tax dollars are invested and grow tax-free in the policy. The cash can then be accessed through policy loans and withdrawals tax-free, including any growth in the policy. This is very similar to a Roth IRA/401(k), where you can invest after-tax dollars, and after age 59 ½ and while meeting other requirements, you can take withdrawals without being taxed on the growth. The advantages to permanent insurance unlike Roth IRA/401(k)s, is there is no income limit that restricts who may contribute, as well as no penalties for withdrawing cash before age 59 ½ or before other requirements have been met. In addition, in life insurance, there is no restriction on how much can be contributed to a policy, aside from the requirements to qualify for the total death benefit and to avoid a MEC. See below for a quick summary of the differences between Roth IRA/401(k)s and permanent insurance policies.
|Roth IRA/401(k)||Permanent Insurance|
|Income Limit to Qualify||Amount depends on tax filing status||None|
|Age Withdrawal Restraint||Cannot withdraw money without a penalty before age 59 ½, unless you qualify under certain conditions||None|
|Contribution Limit||Amount depends on tax filing status||None (but required to buy a certain amount of death benefit)|
|Tax Free Growth & Access||Yes||Yes|
|Death Benefit||No||Yes (also income tax free)|
Designing these types of policies
One of the major objections for using insurance as an investment vehicle for a portion of one’s investment portfolio is that insurance comes with additional costs compared to straight term insurance. While this is true, it is important to note that the death benefit can be minimized in these types of designs to lower the policy costs and enhance the cash value. Depending on the investments and tax bracket of the policy owner, these policies can be designed in a way where the cost of insurance is less than the taxes that would otherwise be paid. This is especially true if an individual is in a high-income tax bracket and is investing in alternative investments or bonds that are generating ordinary income or short-term capital gains. By using life insurance as a wrapper for these types of investments, we can shelter the owner from paying the income tax and/or capital gains tax.
Other considerations and thoughts when using insurance as an investment vehicle
It is important to note that when using life insurance as an investment vehicle, one should have a long-term horizon in mind. Individuals who want immediate access to their investments should not use life insurance because there are acquisition costs in acquiring an insurance policy. Therefore, it takes a few years before the internal rates of returns (IRRs) on cash value begin to look favorable compared to a taxable investment account.
In addition, life insurance should not solely be used to hold all of one’s investment accounts. Life insurance is a good diversifier and, depending on the type of product used, the policies performance may or may not be directly tied to the performance of the overall market.
Who are good candidates for using insurance as an investment vehicle?
Life insurance as an investment is a great alternative for highly paid executives who are maxing out their qualified plans and looking for other tax-efficient places to put their money. Life insurance can be used for those who are skeptical of the market and yet still want a return greater than a risk-free yield. It is often beneficial to use life insurance as a bond alternative for investors who are not currently using those bonds as a regular income source. Bonds generate ordinary income which can be costly for investors in a high tax bracket. In the current low interest rate environment, using life insurance as a bond alternative is especially attractive.
As discussed, life insurance can be a valuable addition to an investment portfolio. We suggest that you consider using life insurance as an investment to help diversify your investment portfolio and take advantage of the tax benefits inherent in life insurance.
The information contained in this article is general in nature and is not legal, tax or financial advice. Investment Services offered through Knox Capital Advisors LLC. Insurance Services offered through Knox Capital Insurance LLC. Investing in equities can result in loss of principle. Past performance does not guarantee future results. In specific cases, clients should consult their legal, accounting, tax or financial advisor. This article is not intended to give advice or to represent our firm as being qualified to give advice in all areas of professional services. To the extent that our firm does not have the expertise required on a particular matter, we will always work closely with you to help you gain access to the resources and professional advice that you need.