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Why Overfunding Life Insurance Makes Retirement Sense

The power of life insurance death benefits inside a comprehensive wealth management plan is well understood. But today, the power of insurance cash values to create a retirement income stream is becoming more and more apparent.

Most advisors understand the concept of leveraging comparatively small life insurance premiums to produce an inordinately large, tax-advantaged insurance death benefit. The concept of “discounted dollars” is well documented and is forever compelling.

In the right circumstances, though, perhaps even more compelling is the concept of tax-deferred accumulation and tax-advantaged distributions that exist in today’s stunning array of life insurance policies. Accumulating large sums in modern life insurance policies can create remarkably efficient income streams for the right client. 

In our wealth management practice, we routinely use “overfunded” life insurance policies in addition to a diversified portfolio of investments in order to help clients achieve a future stream of tax-advantaged income that can be turned on when they retire.

Let’s take a real-world look at one of our professional clients, a 45-year-old man we’ll call Fred.  He earns a significant income and therefore is able to afford to maximize his various investment programs. Because of Fred’s large income, he has a combined federal and state income tax rate slightly in excess of 45 percent. He wishes to save or invest an additional $25,000 per year for the next 10 years as a portion of his overall investment plan.

He has a wide range of options that can be compared. For this particular comparison, we will include the following: a tax-deductible retirement plan (TDRP), an equity account and a taxable bond fund. To keep a relatively level playing field, we will use an average annual return rate of 6.5 percent for our bond fund. (Yes, we know, good luck finding those bond returns today. But for long-term comparison purposes, please indulge us.) In addition, although long-term stock-based investing historically has yielded higher average annual returns, we’ll use an average of 7 percent yearly for the equity fund and lop off a 1 percent management fee. Taxes will be applied as they would normally occur. For example, the tax-deferred retirement plan grows tax-free, but when distributions begin, income tax is taken out, assuming Fred remains in his current tax bracket for life.

For Fred’s potential life insurance policy, we will use a commercially available indexed universal life insurance policy, linked to the S&P 500 stock index (with other indexes available) and assume a return of 7 percent annually. The initial death benefit is $1.13 million, based on Fred’s preferred health status. The policy premiums are structured to comply – just barely – with modified endowment contract guidelines, so as to preserve the tax-free internal buildup of values under current tax law as we understand it. In plain words, we want as high a premium as possible within these rules.

Look at the results for the next 20 years prior to Fred’s retirement (see chart 1 on page Sidebar). As we can see, life insurance policy values compare exceptionally well with the other alternatives over 20 years. The $1 million-plus life insurance death benefit is a nice advantage over other investments. 

But the real advantage is likely to come as Fred enters the “distribution phase”. That’s the time Fred can begin to withdraw money from the various alternatives. This illustration uses a $46,185 annual withdrawal amount, net to Fred.

A look at the next 10 years, when Fred is between the ages of 65 and 75, is enlightening (See chart 2).

By the time Fred is 75, the taxable bond fund has gone to zero and there are no more distributions available. The same is true of the equity account. Zero. The tax-deductible retirement plan (TDRP) still has $176,762, enough to provide income for an additional four or five years.

By contrast, the life insurance policy surrender value is still $310,193, and allows for at least another 10 years of $46,185 annual payouts under the original set of assumptions. Also, the life insurance death benefits are still in force, at $384,730 in year 30. 

To be sure, a widely diversified set of strategies and investments is a good idea for Fred in regard to saving for retirement.  An overfunded life insurance policy might just be chief among them.

LUTCF, is a Top of the Table member with multiple Court of the Table qualifications over his 25 years of Million Dollar Round Table membership. He and Jeremy L. Davis, CFP, ChFC (a Court of the Table qualifying MDRT member), are partners in the Colorado-based wealth advisory firm J.L. Davis Financial Corp. [email protected].


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