[Editor's Note: I received this guest post from financial advisor Bryan Kuderna, CFP, LUTCF. Like most of the stuff I see written about whole life insurance, it focuses on the positives and ignores the negatives, so I felt it should be run as a Pro/Con post. We have no financial relationship.]
Pro – Why Would Someone Want to Finance Whole Life Insurance Premiums? — Bryan Kuderna CFP, LUTCF
The Multiple Risks to Real Estate Investors
Money is an esoteric object. Most people are content holding it, clinging to dollars as if they will inevitably be lost like a toddler outside of its playpen. Some more daring individuals cautiously let those dollars wander just down the block into an investment account, going to work but still quickly within reach. Then there is a select group of wealthy people who seem to despise holding cash.
Real estate is the 3rd largest creator of wealth [behind finance and retail entrepreneurs] among the ultrarich, responsible for 163 billionaires (like our President). Such investors obsess over getting multiple uses of the dollar, using the same funds over and over into project after project. They don’t see a dollar being worth a dollar, but rather a dollar that can hypertrophy into a fortune with repeated exercise. Investing in real estate can be a prosperous endeavor, but not one without risks. The bulk of these financial perils stem from the double-edged sword of leverage and illiquidity.
There are a multitude of threats which can seize property — investors favorite asset. Creditors are quick to identify real estate because of its tangibility and value, making it an easy target for creditor claims. Healthcare costs are at the forefront of everyone’s mind these days, and real estate investors must be ready for costs of care like anyone else. The unfortunate loss of a breadwinner can send an investor’s family into a downward spiral even with well-laid plans. An investment partners’ death or disability can suddenly force the surviving members to handle multiple responsibilities, financial and otherwise. Then there is the unexpected downturn in the economy.
Last, but not least, Uncle Sam impatiently waits for his stake. The Tax Policy Center estimates that in 2017 there will be 5,500 Federal Estate Tax Returns subject to tax. Considering that an estate does not get taxed until it exceeds the $5.49 million exemption, that means there’s a lot of super rich Americans transferring wealth each year. Tax Payer Relief Act of 2012 allows for “Portability”- the use of a deceased spouse’s estate tax exclusion, making the effective combined exemption for married couples nearly $11 million. Even though this tax will only hit 1 out of every 487 American decedents this year, it should generate $19.9 billion of tax revenue to the US Treasury. Almost all of these returns will possess real estate.
The panacea to any financial problem is typically cash. But the Donald Trumps of the world don’t just horde dollars waiting for a rainy day. So, how does one eat their cake and not get poisoned by it too?
Whole Life Insurance as Leverage
For ages, one of the most popular methods of replenishing lost wealth has been life insurance, particularly Whole Life Insurance. Whole Life typically allows an individual to buy a guaranteed and growing death benefit. The leverage is exaggerated even further via the unique income tax-free treatment afforded to life insurance by our tax code, which can also be estate tax-free if set up correctly [i.e. placed in an irrevocable trust-ed].
Real estate investors have many needs for permanent life insurance. It can serve as the vehicle to cover estate taxes and probate costs for a wealthy family. It’s often the funding mechanism for a buy-sell agreement amongst multiple investment partners; should one pass away his/her surviving spouse’s shares can swiftly be bought out by the life insurance proceeds. The cash values can become a side fund for business operations. Life insurance creates an influx of capital when needed most by a family or business, and creates a multiplying effect of current day assets for legacy purposes.
Q. But How Do I Pay for the Large Premiums?
A. Premium Financing
Who Would Benefit by Using Premium Financing?
As we’ll see, real estate Investors make ideal candidates for premium financing. The target market typically includes business owners who can’t touch working capital without disrupting operations, investors who may have assets that have experienced a down market who can’t bear the thought of selling at a loss, individuals with established gifting programs that large premiums could interfere with, clients with assets whose liquidation could trigger large capital gains or people with appreciating assets who would rather maintain ownership until death to utilize step up in basis rules under section 1014 of the tax code.
How Do I Secure Premium Financing?
So how does one go about securing a legacy for generations using premium financing to purchase their Whole Life Insurance policy? Here’s a quick overview…
- Have an attorney draft an ILIT (Irrevocable Life Insurance Trust). This will ensure the policy is held out of your estate, eliminating potential estate taxes, and providing detailed instruction for disposition of assets after your demise.
- Identify a lender. Usually, the lender will be fronting 100% of the annual premium for a term of 1-10 years. On high six-figure premiums, lenders like to see creditworthy customers with net worth well over $3-5 million.
- Have the trustee of the ILIT obtain Whole Life Insurance policy, policies with a focus on high early cash values can be extremely helpful. The importance of having a good credit history and dividend track record of the insurance company cannot be overstated enough. Close the loan with the lender.
- Lender pays the carrier the premium directly. A collateral assignment is placed on the policy to help secure the loan.
- Client creates an exit/rollout strategy through GRAT (Grantor Retained Annuity Trust), sinking fund or similar strategy that coincides with the expected loan termination date. Other exit strategies include a “planned event” such as the sale of business, sale of a property, inheritance, or even the use of some of the Whole Life policy’s cash surrender value.
- The exit strategy pays off the loan.
- Upon the insured’s death, the net proceeds are received by the ILIT and paid out accordingly.
The result of this plan is the acquisition of a significant permanent life insurance policy with the out-of-pocket costs (loan interest payments) of a similar face amount term policy. Clients are often advised to use Whole Life Insurance because the dividends from mutual carriers are closely correlated to prevailing interest rates. The rising cash value helps to mitigate the interest-rate risk associated with a variable premium finance loan.
Once interest-rate risk is planned for, the main hazard left with this strategy is the loan termination/exit strategy. Just as a business owner with no succession plan leaves his/her retirement in jeopardy, so does the recipient of premium financing without an exit strategy.
Purchasing life insurance using premium financing is not for everyone; frankly it’s not for most. But for the high net worth individual shying away from large annual premiums, this may be an option worth further exploration.
Well, we certainly agree about one thing- purchasing a whole life policy with borrowed money isn't a great idea for most. No long-term reader of this blog is going to be surprised to see me writing the “Con” position on this topic. I mean, let's try to think of a way to make a whole life insurance purchase even worse than it usually is….I know, let's do it with borrowed money! Brilliant!
That said, I'll be the first to admit there are some niche uses for whole life, and Bryan's post briefly mentions a couple of them. Remember that one of those niche uses IS NOT for a newly graduated attending owing $300K in student loans to use as an additional retirement fund along with some vague estate planning/asset protection uses, despite the fact that that seems to be the main way they are sold.
Whole Life Making Sense?
So when does it sometimes make sense to buy a permanent life insurance policy? Mostly when you have a need for a permanent life insurance benefit. These can include providing liquidity at death for someone with a large illiquid estate and for business transitions, particularly partnerships where the agreement calls for a deceased owner's heirs to be bought out by the other partners in the event of their death. Of course, this need can often be met with a much cheaper guaranteed universal life (GUL) policy, which typically costs about half as much in premiums as a whole life policy (or even an ultra-cheap term policy sometimes). The downside being there is no accumulated cash value to borrow against during life and the insurance amount also doesn't slowly grow at about the rate of inflation. So the first question is really should you buy a whole life policy at all? The answer, most of the time, is no. But if you're convinced you have a reasonable use for it, then you can move on to the second question.
But Should You Borrow to Pay Premiums?
Assuming a whole life policy is right for you, should you buy it with borrowed money? Mr. Kuderna glosses over all the important details about this in his post and almost makes it sound like a magic solution to somehow create wealth. Last I checked, borrowing money isn't free. There's actually a cost to it. Perhaps an origination fee to the loan, and certainly ongoing interest. Whether those fees and loans are paid now, or whether they are financed along with the rest of the loan, there is a cost there. It's quite possible, even likely, that the cost of that loan exceeds the return on that whole life policy, particularly in the first decade after purchase. A typical whole life policy doesn't even break even on its premiums for 10-15 years. If a policy is designed properly (paid up in fewer years like a 7-pay policy and/or minimizing commissions through the aggressive use of paid up additions), you might be able to shorten that period to 5 years or so.
The typical cash value returns on a reasonably well-designed whole life policy purchased today and held for decades are 2% guaranteed and 4-5% projected. The return on the death benefit is typically slightly better. So if you're paying 6% interest, and even in the very long term only getting a 3 or 4% return on your money, you're coming out behind if there are no other benefits. It's not “whole life for the price of term.” You have to count not only the interest payments (which you do have to cover as you go along) but also the premiums themselves will be subtracted from the death benefit prior to your heirs being able to use any of it. That is going to substantially reduce the amount of liquidity this policy can provide, especially in comparison to funding it with cash instead of borrowed money.
Could It Work For Someone?
So, assuming it is actually costing you money to do this sleight of hand in an effort to avoid capital gains taxes during life and/or estate taxes after life, that cost must be lower than what you are saving in taxes by introducing this complexity into your plan. I'm sure there is someone for whom it would be a good idea to finance the premiums. I can think of a hypothetical business that needs a key-man policy to pay for a buyout but doesn't actually have the cash flow to make the premiums. It's quite a business risk to take on that additional leverage, but it may be better than the alternative of being stuck in business with the deceased partner's heirs. I can also imagine a wealthy retiree who is cash poor but property rich, and with property with very low basis, especially if it has been fully depreciated. Assuming there is also a need for a permanent policy in this situation (in order to split an inheritance without selling the asset at fire sale prices right at death or in order to keep an expensive asset in the family for instance), then this could work out well. Avoiding the capital gains taxes that would be due if a property were sold prior to death in order to pay the premiums could be a substantial benefit worth the costs of borrowing the money.
However, one should keep in mind that over the years, the required interest payments on these borrowed premiums are going to get higher and higher. In fact, just covering the interest payment could eventually exceed the gift tax allowances.
A 10-Year Plan?
At the end, in his discussion of exit planning, Mr. Kuderna seems to be advocating a 10-year plan for this scheme. Not only is the loan to purchase these premiums variable (with no assurance that the dividends will rise accordingly), but if that loan is due after only a decade, you could really be in a fix when it comes due, assuming you're still alive. You'd darn well better have a bulletproof exit strategy, because borrowing against the cash value after only a decade isn't going to be a good one. The cash value is probably going to be very similar to what you owe the bank at that point, leaving you with little cash value and little net death benefit. There's little point to even having a policy after doing that. A 10-year loan just doesn't mix very well with a life-long insurance policy, even if the premiums are only paid over 10 years or less. Now if you know a property or business will be sold or an inheritance will be received to cover that bill, then sure, it could work out okay. But you're not saving the capital gains taxes due on that property or business in that case, just delaying them a few years, which is a much smaller benefit.
The Devil is in the Details
In reality, financing your whole life insurance premiums isn't keeping you from paying them or helping you get the policy at a cheaper price, it is just delaying when you pay them by a decade, and adding additional cost and complexity to your financial plan in exchange for that delay. The devil is always in the details, so if you think this could work for you, you really need to get into the nitty-gritty details of every one of the many moving pieces (loan, trust, policy, exit-plan, tax consequences) of this complex transaction. Complexity generally favors the seller, not the purchaser in financial transactions. I can easily see this scheme being oversold by an overzealous or less than scrupulous insurance agent looking to pocket a $100K+ commission! Certainly, this sort of a transaction would be much less likely to be useful to the typical physician who does not have a lot of illiquid assets and dies with an estate much smaller than $5.5M ($11M married.)
What do you think? Have you financed your whole life premiums? Why or why not? Comment below!