Tax-advantaged investment strategies (courtesy of flaws in the tax law) are the kinds of things they don’t teach you when you become a lawyer, CPA or professional advisor. The Internal Revenue Code is generous to life insurance. Here are three scenarios to illustrate how taking advantage of tax-law flaws can be a key element of a profitable investment strategy.
• Scenario 1. The dollar amount you must earn to leave your kids/grandkids $1 million is $3 million. For example, if you earn that $3 million and are in a 40-percent tax bracket (35 percent Federal, plus 5 percent State), you are bludgeoned with an income tax bill of $1.2 million. Only $1.8 million is left. When you get hit by the final bus, the 45-percent estate tax robs $800,000 more, leaving your heirs that $1 million. This is not a pretty tax picture.
• Scenario 2. The dollar amount you must invest in a life insurance product to leave $1 million to your kids/grandkids is $272,235. Of course, your investment (premiums) will vary depending on your age and health, but as an example, my insurance guru quoted $18,149 per year, making the total premium $272,235 for a 15-year policy. Your $272,235 investment will get your heirs $1 million—all tax-free—from the insurance company.
• Scenario 3. The cash surrender value (CSV) of your policy earns money, growing tax-free. Your profit (the excess of your death benefit over your premiums cost) is tax-free income, as there are many ways to keep the death benefit of your policy free of the estate tax monster.
Using the above example: Your after-tax cost of $272,235 (investment in the form of premiums) does the work of earning $3 million to leave $1 million to your heirs.
Now, using the basic concepts above, let’s take a look at three life insurance strategies.
• Strategy 1. “Health Guard,” which combines long-term care (LTC) and life insurance. Mary is 65 years old and wants LTC coverage. She’s healthy now, so she wonders how smart it is to pay premiums if she never needs LTC.
Enter Health Guard: Mary pays a one-time premium of $100,000. Here’s how the policy works: She can get the $100,000 back at any time (prior to a claim). If she never has an LTC claim, the policy is considered a life insurance policy and will pay a death benefit of $166,406. Whenever Mary has an LTC claim, it reduces the death benefit—dollar for dollar—by the amount of the claim. Health Guard is a smart idea for smart people who are considering LTC.
• Strategy 2. The “Charity Loan Tax Magic” (CLTM). It’s been predicted that contributions for the nation’s largest charities will decline by about 9 percent this year. Ouch!
Here’s a strategy that will help you and your favorite charity. The strategy works at any age, but let’s use Joe (age 60) as an example. Joe is earning 4 percent per year (subject to a 40 percent income tax) on a $1 million investment. Joe would love to give part of that $1 million to his favorite charity, but he doesn’t want to give up any of that $40,000 of income or reduce the amount that will ultimately go to his kids.
Let’s see how the CLTM strategy is a win-win for Joe and the charity. First, Joe creates a family limited partnership (FLIP) and lends it $1 million, payable at his death, with interest at 4 percent per year ($40,000). Then, the FLIP purchases a $1 million policy on Joe’s life (with an annual premium of $19,160) and a single premium immediate annuity on Joe (pays the FLIP an annuity every year—starting immediately and for as long as Joe lives—) for $59,160.
Every year (until Joe dies) the annuity will come into the FLIP and go out with $40,000 interest to Joe and a $19,160 payment on the $1 million policy premium, for a total of $59,160.
Three cheers for charity! The way the numbers work out above (after buying the policy and the annuity), the $1 million loan has exactly $114,972 leftover, which is immediately donated to charity. Of course, Joe gets a $114,972 income tax charitable deduction. In his 40-percent tax bracket, Joe saves $45,989 in income tax.
Also, every year Joe’s annuity allows him to save money in income taxes so he has more spendable income. Here’s how that works: If his income is $40,000, and his taxes are $16,000, he has $24,000 in spendable income. However, a large portion of the annuity is tax-free, so his taxes are only $9,631. This leaves $30,369 in spendable income. With the annuity, Joe has $6,369 more to spend every year.
And finally, Joe will go to heaven someday. While this fact is nothing to cheer about, there will be more tax savings. When Joe dies, the FLIP will collect the $1 million death benefit and pay off the $1 million loan. The transaction will be structured to sidestep the estate tax on the $1 million, with a tax savings $450,000.