Turning Life Insurance Lemons into Lemonade

Use these strategies to multiply the money you will leave to your heirs.


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Ever wonder why the rich buy so much life insurance? The answer is in the numbers: The crazy tax laws allow you to use this strategy to multiply a small portion of your wealth and end up with millions of tax-free dollars. 

Without using these strategies, how much must you earn to leave your heirs $1 million? Would you believe $3,030,030?

For example, Joe earns $3,030,030, which puts him in the 45 percent income tax bracket and makes his income tax an astounding $1,363,636. When Joe dies, the estate tax monster will get 40 percent, or $666,667, of the remaining $1,666,667, leaving Joe’s children with $1 million.

Life insurance offers a way to multiply the part of your earnings that you will leave to your children. $1 million of tax-free life insurance can equal more than $3 million in earnings. And there are at least two dozen strategies that can turn lousy insurance policies (lemons) into policies with larger death benefits (lemonade) with little or no increase in premium costs.

The following five strategies can create the most tax-free dollars (at little or no cost).

Strategy 1 – The “Short-Pay” Lemon
Joe had an offer to buy a $3 million policy on his life for a $66,600 premium, payable annually for 15 years. Such plans are called “short-pay” and build a cash surrender value (CSV) quickly. Keep in mind, however, that the CSV disappears when the policy holder dies, so if you, like Joe, intend to keep your policy until your death, the CSV has zero value to you.

Instead of purchasing a short-pay policy, Joe bought a $3 million second-to-die policy that insured his wife Mary and himself for an annual “life-pay” premium of only $27,900. Lemonade.

Strategy 2 – Single Life to Second-to-Die 
This strategy comes up the most often in real-life practice. Jerry is married to Jane. Jerry had a portfolio of five policies that insured only him. These policies amounted to a total death benefit of $840,000 and total CSV of $650,000. Amazing! All those years of paying premiums, and Jerry really had only $190,000 of insurance coverage. Why? Because the $650,000 CSV was really his money. Truly a pile of lemons.

Jerry 1) cancelled all five of the existing policies, collecting the $650,000 CSV; 2) paid $90,000 in income taxes on this profit from the cancellation (the excess of the CSV over premiums paid); and 3) used what remained to purchase $1.32 million of second-to-die insurance. Jerry and Jane will never pay another penny in premiums, and they more than doubled their death benefit for only $90,000. Pure lemonade.

Strategy 3 – Beat the Double-Tax
Jim had $1.8 million in his 401(k). Sounds good, but consider the double-tax math for just $1 of that $1.8 million. If Jim takes $1 out of his IRA, he will pay 45 cents in income taxes, leaving him with only 55 cents. When Jim dies, the estate tax monster grabs 40 percent, or 22 cents, of that 55 cents, leaving Jim’s heirs with only 33 cents. Applying that same math to Jim’s $1.8 million results in $1.206 million to the tax collector and only $594,000 to Jim’s heirs. Lemons.

Unfortunately, Jim is uninsurable. So he used the after-tax 401(k) funds to buy $4.1 million of life insurance on his wife, Janet. The entire $4.1 million will eventually go to their children, tax-free. Lots of lemonade.

Strategy 4 – The Annuity Tax Trap
Jay owned an annuity that was worth $560,000. He paid $130,000 for it 22 years ago, so he had a built-in profit of $430,000. Unfortunately, that $430,000 is subject to the double-tax described in Strategy 3, which would be due if Jay took all or part of the $430,000 out of the annuity during his lifetime. If he held onto the annuity until his death, his heirs would have to pay the tax. Worse yet, the annuity would turn into a terrible life insurance policy with death benefit of only $560,000. Rotten lemons. 

First, Jay annuitized the annuity. He will receive $46,000 every year for the rest of his life. The tax laws make only $39,000 of the $46,000 taxable, producing an income tax of $17,500 and leaving Jay with $28,500 annually.

Guess what that $28,500 can do? Pay the annual premium on a $2 million life insurance policy on Jay’s life. Barrels of lemonade.

Strategy 5 – Premium Financing
Jack is rich. He needs $40 million of insurance for estate-tax purposes, but he would prefer to invest the $1 million required annually for premiums in his various businesses. A strategy called “premium financing” allows Jack to purchase a $40-million policy on his wife Jill’s life for a one-time payment of $1.2 million. Additional premiums will be paid by loans, which will be paid back after Jill dies. (In order to provide for the loan repayment, the policy’s death benefit must be greater than $40 million.) A lake of tax-free lemonade.