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For many years, especially when the estate tax exemption was low, the focus of estate planning strategies with life insurance often shifted to how the minimum premium can be leveraged for maximum death benefit. With the 2016 estate tax exemption at $5.45M for individuals and $10.9M for married couples, and at $5.49M and $10.98M respectively in 2017, the time may be ripe for the planning pendulum to swing back towards a balance between securing the proper amount of death benefit and the opportunity for cash accumulation in permanent life policies.

One of the reasons why clients may find these policies attractive is the potential to accumulate cash value that can provide another source of income to meet their retirement needs. Of course, the need for death benefit must be established first and foremost, along with other savings vehicles such as 401(k)s and/or other qualified planning opportunities are ordinarily maximized before considering additional savings vehicles, such as cash value life insurance.

Nevertheless, for high income earners in their 30s, 40s and 50s who are seeking additional ways to save and protect their family at the same time, cash value insurance can be an important planning tool.

Advantages and basic considerations

Permanent cash value life insurance policies offer tax deferral on the inside cash accumulation, tax-free withdrawals of basis and tax-free loans so long as the policy does not lapse, as well as a death benefit that is income tax-free, pursuant to IRC § 101(a).

Four important general points should be taken into consideration when using cash value life insurance. First, any withdrawals and loans would have an impact the death benefit payable to heirs.

Second, financial advisors and their clients should ensure that the policy is not a modified endowment contract (MEC) and that it stays in force. As long as the policy remains in force until death and it never becomes classified as a MEC, policy loans remain exempt from income tax.

This makes the income tax-free nature of the policy distributions possible, as long as they are managed properly. If the policy were to become a MEC, distributions would be subject to federal income taxation to the extent of gain in the policy. In addition, if the insured is under age 59 1/2, a 10% penalty would apply to taxable distributions, including loans. Similarly, if the policy lapses, whether it is MEC or not, these distributions taxation rules would apply.

Third, the types of products generally considered for these estate planning strategies such as variable universal life and indexed universal life, are all designed to capitalize on cash accumulation.

Fourth, financial advisors and their clients evaluating life insurance for supplemental cash accumulation should consider minimizing the death benefit as much as possible, without causing the policy to become a MEC. In this regard, many insurance carriers can help with designing the kind of policy that would allow clients to minimize the death benefit, while maximizing the cash accumulation potential within the product.A story can highlight the flexibility offered by the additional source of retirement income in cash accumulation life insurance. (Photo: Thinkstock)

The value of cash accumulation 

For many clients who may not own insurance or only have experience with term insurance, it may seem counterintuitive to maximize the funding of a life insurance policy, while minimizing the death benefit. However, after explaining the tax deferral of the cash inside build-up and the opportunity to take tax-free withdrawals and loans to supplement retirement income, many clients will appreciate the potential value of permanent cash value life insurance in their overall planning process.

Focusing on what the money is for and providing case studies and stories illustrating how cash value helps is of the essence here. For example, let’s assume Jane is a 45-year-old executive who has a substantial death benefit need buys a variable universal life policy (VUL), which permits her to allocate the cash value for exposure to market returns on a variety of underlying investment options.

Jane pays $50,000 of premiums for 20 years. Rates of returns vary and death benefits vary by product. Hypothetically, with the premium pattern Jane intends to follow and assuming she is in very good health, her planned premium may allow for an initial death benefit of approximately $1,438,000, which would be paid to her beneficiaries income tax-free if she dies prematurely.

Of note, Jane did not buy the policy only for the need of death benefit, she bought it for the potential of cash accumulation as well. To meet her twin goals, designing the policy the right way is most important. Even though the initial death benefit is $1,438,000, the benefit increases for 20 years to accommodate the premiums without causing the policy to be classified a MEC.

Then in year 21, the death benefit no longer increases. Assuming a hypothetical 8% gross rate of return and a 7.36 percent net rate of return, the cash value of the policy could be approximately $2 million with a death benefit of close to $3.5M, resulting in a potential $2 million to supplement Jane’s other income. Of course, this is a simplified scenario (actual results will vary) to illustrate how a VUL policy could work for Jane in this strategy.

Results may vary based on actual returns and individual circumstances, so financial advisors and their clients such as Jane must take care to manage their policies to help achieve the desired results. Additionally, a personalized life insurance illustration should always include assumed rates of return selected by the client, the impact of 0% investment performance, and maximum guaranteed charges.

Nonetheless, the story highlights the flexibility offered by the additional source of retirement income in cash accumulation life insurance. The cash value could be used to help pay off a mortgage, go on a cruise, or help offset unexpected expenses during retirement such as unexpected health care costs. Whether the cash is used for leisure, general outlays or extraordinary expenses, or not used at all, having the cash available is the part of the story that really resonates with many clients.

Conclusion

For many of our clients who have never owned permanent insurance or who may only have experience with term insurance, the story of cash accumulation life insurance products — whether it is VUL or whole life or indexed universal life — may be brand new. That is one of the reasons why it is vital for cash value life insurance to be revisited. By telling this story to a new generation of clients, financial advisors can further open up planning opportunities for those who need and want additional ways to save.