Would you buy an overpriced car? No. Yet most people (unintentionally) buy overpriced insurance. Maybe a better way of explaining this wealth-building point is to say, would you like to buy a new car for a 40 percent discount?
What does a low price for a car have to do with real-life overpayment for life insurance? Well, let’s follow the money. Suppose you (as the owner of your business) put $10,000 into a 401(k) plan or other qualified plan. Assume the business is in a 40 percent tax bracket. Because the business gets a deduction for the contribution to the plan, it only cost you $6,000, because in effect, the IRS put in the other $4,000.
Let’s look ahead. Assume that after 10 years a total of $100,000 was contributed for your benefit. The cost to you as owner, after taxes, is only $60,000, and the current value in the plan for your benefit (after dividends, interest and growth in value of the investments) is $200,000.
Okay, you want to take some of that money out. Of course, after you reach age 70 1/2, you must start taking distributions. Now you must pay the piper back. Every dollar you take out will cost you a 40-cent toll charge (assuming you are in a 40 percent tax bracket).
What most people don’t know is that almost all qualified plans can buy life insurance in the plan on your life or second-to-die on your life and your spouse’s life. Yes, even a rollover IRA can join in the tax-saving fun.
For example, if your insurance premiums are $10,000 every year, you must earn $16,667 and pay an income tax of $6,667 to have the $10,000 left to pay the premiums. But wait—if your qualified plan pays the $10,000 premium directly to the insurance company (instead of you taking a $10,000 distribution), you save 40 percent (or $4,000) on each $10,000 you would have taken as a distribution from the plan.
What a great tax deal! When your qualified plan pays your premium, you save taxes three times: (1) when the money goes into the plan you get a deduction; (2) as the value of your plan account grows tax-free; and (3) when you use those plan dollars to pay a permitted personal expense such as life insurance premiums.
Substitute your own numbers. You’ll save enough to buy almost any car with the IRS’s money. Plus, there’s a bonus. Properly structured (using a subtrust), you can keep the life insurance proceeds out of your estate (saving 55 percent of the insurance proceeds under the current estate tax law).
The following real-life examples should get your tax-greed glands activated:
- A 64-year-old business owner has his profit-sharing plan pay a $24,486 annual premium for $1 million of life insurance.
- A 45-year-old man (owns 50 percent of a family business) and his 48-year-old wife have $3 million of second-to-die coverage. His 401(k) plan pays the entire $9,489 annual premium.
- A 58-year-old business owner (Joe) had $915,000 in a rollover IRA. Joe was paying annual life insurance premiums of $17,047 for $1.5 million of coverage on his life, and the policies had a cash surrender value (CSV) of $247,000. Joe no longer needed single-life coverage, but he needed more insurance. Here’s what we did: (1) Joe pocketed the $247,000 CSV (tax-free) and canceled the old policies; (2) The IRA was rolled back into a new profit-sharing plan in Joe’s company; (3) $6 million of second-to-die insurance (with Joe’s wife Mary, age 57) was purchased by a subtrust of the profit-sharing plan for an annual premium cost of $47, 985. The IRS will pay 73 percent of the premium while Joe and Mary create $6 million in tax-free wealth. Note: Joe did not buy a new car with his savings. He bought a boat.