By Chris J. Roe, CPA, PFS
Life insurance is typically viewed through a specific lens – as a tool to meet essential needs such as clearing off debts, funding education, or providing for the family in case of an untimely passing. With its lower premiums and customizable term periods, term life insurance is often sufficient to cover these family needs during wealth-building.
But the question arises – what about permanent life insurance for those who already possess wealth and don’t require term insurance to cover premature death? Many consider it unnecessary, aside from estate planning. Given the current estate tax exemption at over $23 million for a married couple, the necessity for life insurance to cover estate tax has diminished considerably. However, our perspective at Rx Wealth differs.
We believe life insurance is a distinctive asset class akin to a bond within a wealthy family’s portfolio. The U.S. Congress has provided generous tax advantages for life insurance. The death benefit is tax-free, the cash buildup grows tax-deferred, and any sale of underlying investments within the policy is tax-free. In certain scenarios, policyholders can even avail themselves of tax-free cash-value loans. Upon the policyholder’s death, these loans are extinguished tax-free.
With these considerable benefits, why is life insurance often disregarded in a wealthy family’s portfolio?
Common objections include perceived high costs, complexity, the time required to fund premiums, and the belief that “we have plenty of wealth, so there’s no need for life insurance.” While some of these concerns are not baseless, they often stem from a needs-based perspective and overlook the potential investment and tax-saving benefits unique to life insurance.
So, let’s make the case for life insurance as a cornerstone of a wealthy family’s assets.
Life insurance is not influenced by traditional investment portfolios or businesses, making it a potential counterbalance to market volatility. By potentially boosting the overall after-tax returns from a wealthy family’s bond investments, life insurance can serve to smooth the fluctuations a family’s wealth may experience over multiple generations.
The primary reason, excluding a specific need, for purchasing life insurance should be based on an anticipated rate of return to life expectancy and should be designed to claim the death benefit at some point in the future. Quick access to the cash value should be a secondary consideration. With a properly structured policy, the family can know the rate of return on their policy investment at any time, providing stability in an unpredictable market.
For example, Rx Wealth recently worked with an affluent family with variable life insurance policies, which came with no guarantees as to the length of the policy’s validity. One such policy was at risk of lapsing when the mother reached age 93 unless significant premiums were paid. Additionally, these uncertain policies were subject to the risk of underperformance, especially as the insured individuals aged and insurance costs escalated.
Understanding these concerns, we helped the family restructure their life insurance portfolio, moving them away from their unpredictable, unguaranteed variable policies and transitioning them to a more stable plan. The new plan offered potential returns of around 4-5% after-tax or 6-7% pre-tax to their life expectancy. This strategic shift provided the family with confidence in their wealth transfer plans and offered them an above-average after-tax rate of return.
Securing Children’s Inheritances with Life Insurance
If your goal is to spend down all assets by your death, life insurance may hinder this plan. However, most wealthy people I meet have the desire to pass some wealth to their children and own some bonds within their family’s investment portfolio. For those who have this intention and are keen on potentially enhancing after-tax returns of their family’s multigenerational wealth, integrating life insurance into the family’s investment assets should be considered.
Life Insurance: A Tax-Smart Investment Strategy
Being in the highest tax brackets, wealthy families often find their investment returns in taxable accounts diminished due to taxes on interest, dividends, and capital gains. The recurring tax burden on realized capital gains also poses a significant challenge to our goal of rebalancing portfolios. However, if properly structured, life insurance can facilitate the long-term deferral or even complete avoidance of tax on investment earnings and realized capital gains. This approach could be a formidable tax planning tool. When properly owned, the death benefit from life insurance is free from income, inheritance, and estate taxes, making it even more appealing.
Life Insurance as an Asset Protection Vehicle
The importance of life insurance as an asset protection instrument is often overlooked. In numerous states and under bankruptcy circumstances, life insurance is treated as an exempt asset. In other words, creditors have a hard time reaching into the cash value.
Life Insurance as a Tax and Estate Planning Tool
Wealthy families often resort to trusts to transfer assets and future appreciation outside their taxable estate, thereby mitigating estate tax. However, assets held outside a taxable estate forgo the step-up in income tax basis upon death. The decision usually makes sense as you save over 40% in estate tax on the total value of the assets, in contrast to paying over 20% in capital gains tax on the appreciation. In the majority of instances, this is a favorable trade-off.
However, consider the scenario where the trust assets are invested in a life insurance policy on the life of the grantor or both the grantor and their spouse. This strategy enables the assets to enjoy tax-preferred growth during the insured’s lifetime and also acquire a step-up in basis upon the insured’s death, as the death benefit is paid out tax-free. This method can provide a significant tax advantage for wealthy families.
The key to unlocking the full potential of life insurance is to actively manage it as a crucial part of overall wealth, not merely a set-it-and-forget-it item. With frequent reviews and adjustments, life insurance can act as a powerful asset in a wealthy family’s portfolio, keeping pace with changes in the market, health conditions, and innovative product offerings.
At Rx Wealth, we help our clients ensure that their customized strategy consistently meets their needs. We review a client’s insurance portfolio annually because the insurance market constantly evolves with new, innovative products providing enhanced benefits over existing products. Additionally, as clients age, their health changes which may alter our funding strategy to potentially enhance the overall returns realized at death. Our annual review ensures our wealthy families’ customized strategy meets their needs.
If it has been a while since your family has reviewed their life insurance portfolio, please schedule your initial consultation here.
Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at firstname.lastname@example.org, or on the web at rxwealthadvisors.com.