The Internal Revenue Code is generous to life insurance. To illustrate how taking advantage of tax-law flaws can be a key element of a profitable investment strategy, I'll first introduce three concepts.
1) The dollar amount you must earn to leave your kids $1 million is a whopping $3 million! If you earn that $3 million and are in a 40% tax bracket (35% Federal, 5% State), you're bludgeoned with an income tax bill of $1.2 million. Only $1.8 million left. When you get hit by the final bus, the 45% estate tax robs $800,000 more... leaving your heirs that $1 million. Not a pretty tax picture.
2) The dollar amount you must invest in a life insurance product to leave $1 million to your kids is only $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.
3) The cash surrender value (CSV) of your life insurance 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. Let's summarize. 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 two life insurance strategies that few professional advisors know about.
1) "Health Guard," which combines long-term care (LTC) coverage and life insurance. Mary is 65 years old and wants LTC coverage. But she's healthy now and wonders how smart it is to pay premiums that would be a waste if she never has a need for 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 a LTC claim, the policy is considered a life insurance policy and will pay a death benefit of $166,406. Whenever Mary has a 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.
2) The "Charity Loan Tax Magic" (CLTM). It's been predicted that contributions for the nation's largest charities will decline by about 9% 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% per year (subject to a 40% income tax rate) 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, nor does he want to 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 loans it $1 million, payable at his death, with interest at 4% per year ($40,000). Then, the FLIP purchases a $1 million policy on Joe's life (annual premium $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% tax bracket, Joe saves $45,989 in income tax. And then every year Joe saves (because of the annuity) income taxes and has more spendable income.
And finally, someday Joe will go to heaven. No cheers. But 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 $1 million, yielding an estate tax savings of $450,000.