In the last post
I spoke about the use of cash-value life insurance to grow wealth with very little risk to principal, a very competitive rate of long-term growth, and tax-free withdrawals through the use of policy loans. What's not to like?
How is this accomplished? Through the overfunding of your policy. Let's say your monthly premium is $100. What if you contributed $1000? Universal life policies are designed to allow excess contributions. Now...a word of caution here: a few years ago the IRS caught on to this concept of insurance policy overfunding, for the purposes of avoiding taxes, and set some rules (mainly the 7-pay rule, which I won't go into here) to prevent the abuse of these tax rules. Basically, if a policy violates the 7-pay rule, it is then designated a Modified Endowment Contract by the IRS, and the tax advantages largely disappear. However, the 7-pay rule is very generous, and overfunding of policies can still be done to a high level without creating a MEC. This is why you want the help of an advisor to avoid making a tax mistake that can bite you when you begin to take distributions.
How do the distributions happen?
At some point you'll probably want to begin taking some distributions against your contract. You'll do that through the use of loans against your policy.
There are two kinds of loans available inside most cash-value policies, wash loans and variable loans.
- Wash Loans: the interest on the loan will equal the rate of growth on the cash value inside the policy. This is a good thing, because the cash in the policy won't have to be used to pay the interest on the loan. If the interest on your loan is 7% the insurance company will credit 7% to the cash value in your policy. It's a neutral transaction from the insurance company's point of view.
- Variable Loans: allows the client to borrow money from the company at whatever the fixed rates happen to be at the time of borrowing. If the cash value grows at a higher rate than the fixed rate, you can actually make money on the money you borrowed from your policy! This can be powerful.
Historically the S&P 500 has returned more than 2% each year than the borrowing rate used for loans!
Most insurance agents don't understand how these loan rates affect the products they sell, and will typically manipulate the illustration software and use an unrealistically low lending rate and no maximum lending rate to show you a better result than you're likely to get! Be careful.
The End Result...
If done properly, can be quite impressive. Using an Equity Indexed Universal Life policy, which locks in your gains each year, coupled with a realistic illustration from a stable, reputable company that maximizes a positive arbitrage on your loan, you can accumulate a valuable asset with huge tax advantages, available for you in the time of life when you'll be most grateful for it.
The key is using a reputable insurance company who has a good track record with historically favorable arbitrage rates, and an advisor who knows which companies those are (hint, hint),
Till next time,