In the previous three parts, we’ve espoused the potential benefits of a properly structured Life Insurance Retirement Plan (LIRP) within a well-rounded tax-free retirement strategy. Here in Part 4, let’s get down to some brass tacks that are important to consider. We will cover:
- How a LIRP is tax-free
- The tax-free term insurance death benefit
- Tax-free long-term care provisions
- liquidity provisions with potential positive arbitrage
- Structuring a low-cost LIRP
- What to look for when choosing a LIRP company
Just fair warning, this section is going to be more technical than the others. You may or may not want this level of detail, and I struggled with the decision to include this much detail, only from a desire not to numb your brain into needing to binge watch several seasons of The Office to recover. But, I decided to risk it (you’re welcome).
You do not need to be an aeronautical engineer to appreciate and experience the wonders of flight. Whether or not you intimately understand the laws of aerodynamics, the airplane will still fly. Similarly, a properly structured LIRP has the potential to function in a very beneficial way for you, whether or not you fully comprehend everything going on internally. That’s what good financial professionals are for. Feel free to skip around in this section and scan the details and highlights to your heart’s content.
In Part 1, we compared a properly structured LIRP to a Swiss Army knife. We have not found a more flexible, more multi-faceted financial tool that has the potential to accomplish and accommodate so many various objectives. A LIRP is nothing more than a maximum funded cash-value insurance contract structured to have the lowest fee structure possible. When setup right, the fees are low and the earning potential is competitive. Here is some techno-babble to help you understand the guts and workings behind the curtain.
There are 3 ways to access the values inside your LIRP: the dumb way, the smart way, and the sad way. This also comes to how a LIRP is tax-free. In techno-speak, a LIRP grows money in a tax-deferred manner but has liquidity provisions that allow you to access those values free of tax at any age without IRS penalties.
The Sad Way
This is the simplest and most final method of having access to your LIRP values. You die. Everything—face amount and LIRP account values—passes on to your designated beneficiaries income tax-free. The end.
The Dumb Way
Your principle, your contributions, can be accessed through a “withdrawal” without taxation because you used after-tax money to contribute. This is the same function as a Roth with regard to accessing your principle. Now, you can also access your gains through a withdrawal, but this is the dumb way. If you actually withdrawal your gains, they are taxable as ordinary income, just like an IRA/401K or a non-qualified annuity. Not optimal, to say the least.
The Smart Way
In favorable contrast to a withdrawal, the LIRP offers a loan provision which allows you to borrow against your account value (both gains and principle if you desire). Since loans do not generate a 1099, they are not taxable. Technically, they are not income at all. When you obtain a mortgage, do you have to pay taxes on that amount? No. What about a car loan, or when you use your credit card? No, because it's a loan, not income. Loans are not taxable.
But, loans often come with a cost, right? An interest rate, transaction fees, etc.? Unlike banks, LIRP companies are not in the business of making money through loans. You'll find the loan provisions of the LIRP extremely friendly, the best LIRP companies providing net-interest free and cost-free loan provisions. In fact, loan provisions have existed for more than 100 years as a legal construct for you to access your LIRP values in a tax-free manner, not for the insurance company to make money. While the word "loan" colloquially has a negative connotation, that is not the case here.
There are generally two different types of LIRP loan provisions.
Wash Loan/Net-zero Loan—
With this loan type, when you access your values through a loan, the insurance company is loaning you their money, using a portion of your account value as collateral. This is important to understand: it’s a loan on your money, not from your money. In other words, 100% of your account value is still there, inside your LIRP. Let’s do an example.
You have a $100,000 account value in your LIRP and want to access $10,000 tax-free. You tell the insurance company you want to access that amount through a loan. They send you a $10,000 loan from their coffers. It’s done within a week usually. No credit application, no hoops to jump through, no transaction fees. Done. The insurance company then earmarks $10,000 of your account value as collateral and sets it in a collateral account. You now have $90,000 in the index-based accounts in your LIRP and $10,000 in a cash account as collateral. Net effect? You accessed $10,000 tax-free.
The insurance company must charge an interest rate on the loan in order for it not to be disallowed by the IRS. So, they charge a 4% rate, for example. But, what about your $10,000 in the collateral account? They will pay you an interest rate of the same amount they are charging you. So, 4%, washing out the interest charged. The result is a net-zero interest/cost loan, which is why this is often referred to as a "wash loan". It does not have to be paid back during your lifetime, but you can if you want. If you have taken a loan early in your policy’s life, it is generally advisable to pay back the loan. Many times, people pay it back through their death benefit when they pass away.
Brilliant, right? In essence, you accessed money based on your LIRPs values in a tax-free, cost-free, interest-free manner. This can be done at any age, without IRS age restrictions. In general, you can access up to 90-95% of your surrender value in this manner. This is fantastic liquidity.
This type of loan is where we start to see some great opportunities in potential positive arbitrage, potentially increasing the tax-free income a LIRP can provide significantly. When accessing a loan with an index or participating loan, instead of a portion of your account value being placed in a collateral cash account, it is still "earmarked" as collateral but left in the index-based strategies you have chosen. Let’s again show this through a simplified example.
You have $100,000 in your LIRP and wish to take a tax-free loan of $10,000. So, you follow the same procedures as before, and then your money shows up within a week (either a check or wired to your bank account). Then, $10,000 of your account value is earmarked as collateral but left in your index-based allocation to hopefully continue earning safe and productive returns.
On the $10,000 the insurance company loaned you, they must still charge an interest rate. Let’s again assume 4%. Now, here’s where it gets interesting. Since your earmarked funds are still in the index-strategies, they have the potential to earn a rate of return above the borrowing rate. This is called arbitrage and is the main way banks make money on your money. They might pay you 1-2% in your savings account, but they’re loaning it out at, say 3-5% on mortgages (and other types of loans as well). The spread between what they pay you and what they charge for the loan is their profit.
With a LIRP, this can work very powerfully for you. If you’ve taken a loan against your LIRP for 4% but have the ability to earn money above and beyond that rate, you have the potential to earn money on money you’re using for something else. Aside from real estate, we know of no other product that offers this feature, certainly not as effective as a LIRP can provide. Further, you can help increase the chances of a positive arbitrage by utilizing the ”Participation Rate Focus" Strategy discussed in Parts 2 and 3 that provides a return higher than the stock market’s return up to a cap. Let’s consider an example:
- Tax-free Loan $10,000
- Borrowing rate: 4%
- Indexed/Participating Loan
- Participation Rate Focus Strategy
- 140% Par Rate
- 10% Cap
- 0% Floor
- Annual Reset and Lock In
- Performance Factor 1.5X Starting Year 3
Assume we took this tax-free distribution as an indexed loan at the beginning of 2005. We didn’t pay it back and don’t intend to. After all, the LIRP’s loan provisions are there for you to have tax-free access to your money. The insurance company is not in the business of making money via loans, like a bank. They don’t care if you pay it back, but you can if you wish.
Tax-free Distribution: $10,000 Index Loan
|S&P 500 Raw Return||Participation Rate Focus Strategy|
|Year||||Rate of Return||||Loan Rate||||140% Par Rate, 10% Cap, PF 1.5X Year 3||||Arbitrage Rate of Return||||$10,000 Earmarked as Collateral||||Net Balance Above Loan Balance|||
We really hope you can see what this means. When you liquidate an account, say a bank account, brokerage account, or a retirement account, do you continue to earn potential growth or any interest on that money from that account? No! You withdrew the money. Of course it’s not still earning returns from the account you withdrew it from!
The LIRP, through the use of the Index/Participating Loan provision, can potentially offer just that. In our example, you accessed $10,000 tax-free through an Index Loan on your account. Since the $10,000 earmarked as collateral on that loan in your LIRP is still in the index allocation (in this example, the High Par Rate strategy), it still continues to earn potential returns linked to the S&P 500 subject to the parameters of the index strategy (remember bowling with bumper rails?). So, if the loan rate is 4% (fairly typical) but you’re earning a tax-free 9.45% on average, what’s really going on? You are earning a positive arbitrage of 5.45% tax-free above the borrowing rate. In other words, you are still earning a rate of return on money you essentially withdrew and are using elsewhere. Maybe you bought a car. Maybe you had an emergency. Maybe you took a vacation. Maybe it’s retirement income. Regardless, with a LIRP, you have the ability to earn interest on money you are otherwise using.
Pretty awesome, right?
So, in the example, even though $10,000 was “taken out,” it continued to earn you an additional $11,541 for your future use. Yes, by distributing money to yourself on a tax-free basis by virtue of an index loan, you still earned money. You were paid to borrow your own money. Now, that’s exciting, but not every year was a winner as far as positive arbitrage. In 2008, the LIRP returned 0% (due to the floor protecting you from the awful -38.49% in the market), but the interest rate of 4% on the borrowed amount still applied. So, you would have paid 4% on the $10,000 (or the loan balance) that year. Now, you don’t pay that out of pocket (unless you really really want to), it simply accumulates in your collateral account, creating a debit that year as you can see from the table above.
The point here is that the index/stock market can potentially help you pay for and earn more than the borrowing rate. Combined with the high par rate and the performance factor enhancement, your chances of having positive arbitrage, especially over time, are significantly increased.
This. Is. Awesome.
Anyone who tells you this is not awesome is a math-bigot.
Don't be a math-bigot.
Think about real estate applications here. You’re 45 years old, well under the 59 ½ age restrictions that 401Ks, IRAs, and Roths deal with. Desiring to build tax-free liquidity at any age, let’s say you’ve diligently accumulated several hundred-thousand dollars over several years in your tax-free LIRP. A real estate opportunity comes along where you can purchase a rental home that will produce about $500/mo in positive cash flow. You need $75,000 to complete the deal. Rather than use money in the bank, which would not give you potential future returns (paltry though bank yields are), you use some of the money from your LIRP by virtue of a tax-free index loan distribution. Over the next ten years, assume you earned 2% above the borrowing rate per year on average, giving you an additional ~$1500/yr in tax-free interest inside your LIRP. What has this done to your rate of return on the real estate deal?
Well, it increased your positive cash flow from $500/mo to essentially $625/mo (due to the $1,500 positive annual arbitrage on your index loan from your LIRP). That’s an increase of 25% on your real estate cash flow. How’s that for some extra juice in your portfolio? You didn’t even have to raise the rent!
Or, perhaps you’re going to purchase a car that costs $35,000. Instead of taking out a loan from a bank, or paying cash from your bank account, you use the money from inside your LIRP through an index loan. Now, this is one where it might be advisable to pay back the loan by figuring out what the car payment would have been to the bank and paying that to your LIRP instead.
So, you take the tax-free distribution from your LIRP and earn 2.5% positive arbitrage on average over the next 5 years. Not only did you not have a car payment (unless you’re paying your LIRP back), but you earned an additional $4,375 on your borrowed funds that you used to purchase the car. How much additional would you have earned if you used cash in the bank? Nada, obviously, because your bank account doesn’t have that $35,000 anymore. Or what if you used a traditional loan from a bank? Well, you would have paid a lot more in interest on that loan, not earned interest on the loan as is possible from your LIRP. Essentially, the positive arbitrage in your LIRP made the car cost that much less. Since cars are depreciating assets, getting them as cheap as possible is a boon. Using this feature of a properly structured LIRP can potentially do that.
Alternatively, what if you put $17,500 down on the car from your LIRP (index loan) and did traditional financing on the remaining $17,500 for the car at a 5% borrowing rate? Still assuming you earned a positive 2.5% arbitrage in your LIRP, that would have made your effective borrowing rate for the car loan only 2.5% (5% rate from the bank —2.5% positive arbitrage return from your LIRP = 2.5% net interest). So, the LIRP’s earning on the index loan helped to mitigate the cost of financing the car. See?
Again, these number are not an official LIRP illustration. Insurance fees would lessen the dollar amounts represented. This is only to illustrate the concept. Regardless, this principle has the power to increase retirement income significantly, which is yet another application. Imagine if your 401K continued to earn you a rate of return on money you took out to live on during retirement, giving you additional money to use in the future. Talk about potentially reducing your risk of running out of money . . .
If you’re going to do a short-term loan from your LIRP, a wash loan might be best. If the loan is going to be long-term or permanent, basically a tax-free distribution, an index/participating loan might be best. Many well-respected LIRP companies allow you to switch loan types once a year on existing loans if you choose, giving you even more flexibility.
There are a multitude of uses that can be imagined for a Life Insurance Retirement Plan. It is not limited to retirement uses and is largely unencumbered by IRS restrictions (unlike qualified plans like 401Ks/IRAs) when set up properly.
Loan Interest: In Advance or Arrears?
Aside from choosing the type of loan you want to use to access your LIRP's values, when the interest is actually assessed is important. This is especially true when doing an Index/Participating loan. There are generally 2 ways in which the insurance companies will assess the interest on the loan:
1. In advance - the insurance comapny charges the interest for the year on the loan you take on day 1 of the loan.
2. In arrears - the insurance company charges the interest for the year on the loan you take at the end of the year.
Why does this matter? Simple: opportunity cost.
It is more favorable to have a loan provision with interest charged in arrears, all other things being equal. This does make a respectable difference overtime in the amount of value your LIRP can potentially provide to you (distributions/cash flow, accumulation, remaining death benefit, etc.); however, it is not the "end all be all". Does a company that charges interest in advance have more flexibility and features than a company that charges interest in arrears? Perhaps the cap rate on the LIRP that charges interest in advance is significantly higher, or the index options are more diverse and robust, or the internal fees are less overall.
This is true with each of the points made here in part 4: be sure to look at these things comprehensively and consider the sum of the pieces. This is where an experienced retirement planner can be of great value.
Death Benefit and Annual Contributions
First and foremost, a LIRP is life insurance, hence the name—Life Insurance Retirement Plan. The costs of insurance are the fees associated with the LIRP, rather than paying management fees, fund fees, and brokerage fees associated with traditional financial vehicles or accounts.
A LIRP is structured in the opposite manner other life insurance policies are structured. Traditionally, you want to purchase as much death benefit as you can for as little premium as possible. This is the essence of traditional term insurance, and even most permanent policies, such as whole life or universal life. With a LIRP, you want to have as little death benefit as possible while shoveling in as much money as you can per IRS guidelines. The IRS says we must have a “minimum death benefit” that comes with the policy in order for it to be considered life insurance and maintain its tax advantages.
Now, let’s ponder this. We get to make use of index-based strategies as described in Parts 2 and 3 within a LIRP AND have a tax-free death benefit above and beyond those potential values. Let’s do a quick check on the value of this “forced” death benefit. Say you’re 40 years old, married, and have a couple kids. You and your spouse decide to open a LIRP and put the death benefit of $500,000 on your life (you can each have a LIRP, by the way). In this same year, you decide to begin contributing to your 401K at work with a 50% match. You put in $10,000 to your 401K, and $10,000 into the LIRP. The next month, you suddenly and tragically pass away. What will your heirs get? Assuming no fluctuation in the market, your heirs will get $15,000 ($10,000 in contributions plus the employer 50% match) from the 401K. If they need to use the money, they will have to pay taxes on that money, leaving them less. Eventually, they will pay taxes on it regardless. From the LIRP, your heirs would get at least $500,000 tax-free. We say "at least" because, depending on how the LIRP is structured, you could get just the death benefit or the value of the index-based account plus the death benefit (there are reasons why you would choose either of those death benefit options depending on your situation). The point is, at least $500,000 tax-free from the LIRP.
Which retirement strategy do you think your heirs value more? LIRPs offer potentially significant "living benefits" (tax-free liquidity and distributions, safe and productive returns, long-term care benefits, etc.), but they also provide an invaluable benefit to your heirs well above the account value should you graduate from this earth early.
Now, assume and your spouse are in retirement, 68 years old, and you have a LIRP with an index-based account value of $400,000 with an accompanying face amount (fancy word for life insurance coverage) of $150,000 above the account value. Also assume you have an IRA of $400,000. You pass away. What’s does the financial picture look like? The IRA becomes inherited by your spouse, complete with the inherent tax bill that will come due sooner or later and all the strings of qualified accounts (see our post on The Tax Columns). By contrast, the LIRP’s account value of $400,000 would blossom into a $550,000 tax-free benefit to your spouse. The end. No more strings, no future taxes or headaches to deal with.
For all the fantastic potential growth features a LIRP can boast, we cannot forget about the invaluable insurance portion of the contract.
Can you purchase more death benefit than the minimum required by the IRS? Yes, but if the goal is to use the LIRP as a retirement tool, we want to minimize fees as much as possible. A policy with a higher-than-required death benefit is going to have more internal friction.
The 7 Pay Premium
In fancy IRS-speak, the 7-pay premium is the annual maximum contribution that can be made in the first several years of the contract until an aggregate maximum is reached. This is the first step in structuring a LIRP, to decide how much per year you want to contribute to it as part of your overall retirement strategy. That answer will then become the 7-pay premium. From there, a calculation is made according to IRS tables that dictates the minimum amount of insurance death benefit that must accompany the LIRP in order to qualify as tax-free. Don’t worry, we have software that does all this for us. So, you determine what you want the contribution limit to be. If that’s $2,000 per year or $200,000+ per year, you get to determine that when you set up the LIRP.
The other factors in determining the minimum amount of insurance that will come with your LIRP is age and gender. For example, assume a 25-year-old male and a 55-year-old male both want to put $10,000 per year into a LIRP. The minimum required death benefit for the 25-year-old will much higher than the minimum required for the 55 year-old. However, the internal fees over the life of the LIRP will be relatively similar regardless.
What if we are already max-funding our LIRPs and have more money we want to put in? Cool. Open another LIRP. No limit. The new LIRP will have a new annual maximum all of its own, whatever you determine it will be. Neat, right? No matter how many Roth IRAs you have, the combined limit is still only $6,000 or $7,000 per year (currently), depending on your age. So, though there is an annual max contribution with a LIRP (one you determine), there is technically no limit to how many different LIRPs you can have.
In our family, we have several, all for different purposes with different companies, taking advantages of different crediting strategies. All tax-free. All highly liquid with tax-free access.
Guideline Single Premium (GSP)
The GSP is the aggregate maximum that you can put into the LIRP until the policy resets. So, assume your 7 pay premium was
$10,000/yr and your GSP is $55,000. You cannot put more into your LIRP than $10,000 per year (without creating tax-issues), but you cannot put in more than $55,000 in total (until the policy resets, stay tuned). Therefore, you can max out your LIRP for 5.5 years, at which point it is considered fully funded. This is where you want to be in order for the LIRP to perform most efficiently for you.
Guideline Level Premium (GLP)
The GLP is the annual limit you can contribute to your LIRP after the policy resets. It is typically lower than your 7-pay premium. The GLP is also critical in the calculation of when the policy resets.
For example, if the 7-pay premium is $10,000, the GSP is $55,000, let’s now assume that the GLP is $8,000. We know we can max out our annual contributions for 5.5 years (7-pay premium of $10,000) until we hit the GSP ($55,000). We cannot contribute any more until the policy resets. This is a simple calculation of dividing the GSP by the GLP. The answers tells us how many years it takes the policy to reset. So, in this case, $55,000/$8000 = 6.9 years. Essentially, beginning in year 7, we could now start contributing to the LIRP again (if we wanted to) up to the GLP, or $8,000 per year. We do not have to do this, but if you have more money you’d like to house in a tax-free environment with all the advantages we’ve previously discussed, you’re free to.
You do not have to calculate all this. It is all done for you by software, and the insurance companies force compliance so that you do not nullify the tax advantages of your LIRP. Translation: this is just stuff you can geek out on and impress your friends at the next social gathering by knowing, but it is not something you have to fully grasp in order to build tax-free wealth using a LIRP.
Making Up Contributions
This is yet another feature of flexibility a LIRP contains that is not had among financial alternatives. Let’s say you set up a LIRP with an annual maximum (7-pay premium) of $30,000. After several years of contributing that amount, you have a financial emergency and can only put in $10,000. So, being diligent and disciplined, you do what you can that year and deposit the $10,000 into your LIRP. That left $20,000 unused of the annual maximum. In every other financial vehicle (Roth, IRA, 401K, etc.), it’s a “use it or lose it” proposition. If you don’t max out your contributions in those vehicles in a given year, you cannot go back in a future year and make them up.
But you can in a LIRP. Think about inheritances, or the sale of a business, or a piece of real estate. Many savvy people set up a LIRP in advance, knowing they are going to have a major lump sum in the future that they’d like to house in a tax-free environment, and fund it minimally for the time being, leaving open a large amount of contribution room for the future lump sum. Do you know of another vehicle that can allow hundreds of thousands of dollars to be contributed at once and offer potential growth that is tax-free? Any taxable account (bank account, brokerage account, mutual funds) will allow any size contribution but you will have no tax advantages. An annuity will also allow large contributions, but the earnings will be tax-deferred, not tax-free. The Tax Columns post spent considerable time on the pitfalls of tax-deferral, remember? Only a LIRP can handle massive contributions and allow for tax-free potential growth when set up properly.
Modified Endowment Contract (MEC)
A MEC is created when you contribute more than the annual maximum allowed, according to your LIRP‘s structure. The LIRP will then become tax-deferred on the gains, instead of tax-free. Ugh. Essentially, it will have the same qualities as a non-qualified tax-deferred vehicle. The death benefit remains tax-free, but the money within the LIRP would be accessed in a tax-deferred manner. Your principle is still accessed without taxation, however.
Don’t panic. If you contribute more than the annual maximum, the insurance company will notify you and give you the option of taking back the money that exceeds the 7-pay premium limit. Some companies automatically refund the overage. The point is you cannot create a MEC without really trying to. The insurance companies are very sensitive to this and will not create a MEC by default. So, there’s really no worries here of "accidentally" screwing up your LlRP’s tax advantages.
Believe it or not, there are uses for a MEC, especially in estate planning or cash-management situations, but those are outside the scope of this section.
Long-term Care Provisions
One of the more exciting features of a LIRP that came into being in the past decade or so is the ability to use the death benefit to pay for long-term care expenses. For many companies, this is a free provision; others charge an additional fee for it.
The main heartburn people have about traditional long-term care insurance is the possibility they could be paying for something they never use. If you need the coverage, you’re very, very glad you have it (have you seen the cost of long-term care recently?). However, imagine paying premiums for 20 years for LTC insurance only to die peacefully in your sleep, having never needed the insurance. Do your heirs get that money? Your surviving spouse? Nope. It’s use it or lose it.
Happily, newer improved LIRPs offer an attractive alternative. In general, it works like this: Say your death benefit on your LIRP is $400,000. As the years go on, you cannot perform 2 of 6 Activities of Daily Living (ADLs). These are a set list of daily functions the medical community at large says we need to be able to do for ourselves independently, such a bathing, feeding, ambulating, continence, etc. So, if you cannot do 2 of 6 ADLs, and have a doctor write a note to that effect, the LIRP’s long-term care provision will kick in. Usually the payout is 2% monthly of the death benefit, or, in this case, $8,000 ($400,000 death benefit X 2% = $8,000 monthly benefit). It does not matter if you receive the care in your home or at a long-term care facility. It does not matter who provides the care to you, whether a family member, neighbor, or licensed medical practitioner. The money is sent to you. How you spend it is up to you, but we hope you use it for its intended purpose. The point is you are in control.
Now, if this provision is free in your LIRP, there might be some discounting of the benefit. For example, if your monthly LTC benefit is $8,000 per month and you are 75 years old, you would perhaps get 75% of the monthly benefit. If you were 80, you would get 80% of the benefit. Keep in mind you didn’t have to pay for this coverage along the way, so the discount doesn’t bother us.
If, however, you are charged an extra fee for the LTC provision, there would be no discounting. But this goes against our grain in that you’re now paying for something you might never use, we prefer the free version.
LIRPs started offering LTC provisions in order to be more competitive with Roth IRAs. Insurance companies knew that if they could offer more benefits and streamline the fees to a lower range, they would attract savvy retirement savers. Speaking of fees . . .
If we could sum up the objections of detractors to using a LIRP, it would be this: "They’re expensive!" Often, so-called "gurus" or radio talk show hosts who say such things are referring to ill-structured insurance policies, and forget that alternatives to the LIRP, such as IRAs, 401Ks, or mutual funds also have fees, including the largest expense in the financial world: taxes. Happily, a properly structured LIRP does not have to deal with taxes.
In comparing the fees within a LIRP to alternatives, we can turn to the most popular retirement vehicle in the country, the 401K. Investopedia reports that 401K fees “[range] from 0.5% to 2.0%”. A study by USA Today found that the average cost to a 401K participant (you) is 1-1.5% per year, taking into account mutual fund options, plan custodial fees, recordkeeping fees, and other costs. And what do we get for paying those fees? A monthly statement? Online access? Hopefully professional management, but that doesn’t help us when a 2008 comes, or a coronavirus scare hits.
Most LIRPs average about the same, around 1-2% a year over the life of the policy. In a LIRP, the fees in the early years will be higher than 1-2%. In the later years, they are often less than the 1-2% average, often significantly less. An ATM example is probably best suited to explain how the fees work in a LIRP. If you go to an ATM that charges $2.00 per transaction, that fee doesn’t change if you withdraw $20 or $200. What does change is the % of the fee. You withdraw $20, the fee is 10% ($2 is 10% of $20). If you withdraw $200, your fee is 1% ($2 is 1% of $200).
This is why a LIRP costs more in the early years but much less in the later years as a % when, you know, you actually need the money. It might make sense to you that having fees be the lowest as a ratio when you are leaning on the money for your retirement is highly beneficial. Only a LIRP offers that type of fee structure.
This is how the fees average about the same as a 401K or portfolio of mutual funds over the life of the plan. However, what we’re paying for within a LIRP is actually meaningful. Tax-free access at any age to the surrender value without IRS penalties. Locking in of annual gains. A guaranteed floor against negative market returns. Long-term care provisions. A death benefit for our families and heirs above and beyond the tax-free account value.
The point is that someone is going to get about ~1.5% per year from your money, whether it’s a CD at the bank (through arbitrage on your money), a brokerage account, a 401K, IRA, mutual funds, or a LIRP. Even so-called low-cost index funds have higher fees than they show, especially when including taxes. As long as we’re paying those fees, we might as well get something useful and meaningful, rather than just an account statement.
So, what does a LIRP cost? When used properly, about the same as everything else. You just get much better features.
- Reasonable rate of return
- Competitive fee structures
All four criteria mentioned earlier in Part 1 that we all seek with financial instruments are possible with a properly structured Life Insurance Retirement Plan. In the end, the IRS allows you to pay taxes on your retirement accounts or for the cost of term life insurance inside a policy. A significant amount of the time, people find that the cost of term insurance inside a LIRP is much cheaper than taxes, especially in light of the fact that taxes are poised to go much higher in the future.
Don’t forget that. Tax-free today is fantastic. Tax-free in the future is going to likely be a requirement knowing where taxes are all-but-certain to go.
One major pitfall people often fall into with LIRPs is not fully funding them up to the annual contribution limit (7-pay premium). The dollar cost of insurance in the LIRP is the same regardless of whether you put in the full annual amount (which you determine when setting up the LIRP) or some amount under that. Recall the ATM example. Continued contributions well below the annual limit will not prove effective for your future. The more you put into your LIRP, the lower the fees as a percentage become. The failure to max-out your LIRP contributions is what can turn a LIRP into an expensive proposition. This is a misuse of the vehicle and is not the vehicle’s fault.
This can occur when unscrupulous insurance agents are involved or when you bite off more than you can chew as far as your commitment to annual contributions.
ASK what your annual maximum (7-pay premium) is. If your agent is pitching a cash-value policy to you as a tool for cash accumulation but isn’t advising you to put in that full amount, ask why not. Part 4 of this post has armed with you with a lot of information you can use to your advantage.
Another pitfall is causing your LIRP to lapse during your lifetime by taking out money too aggressively. The insurance policy itself is the umbrella that keeps the IRS from raining on your tax-free parade. It must stay in force in order for your access to remain tax-free. Some people do themselves a major disservice by using the money in their LIRP too aggressively. This can cause the LIRP to potentially lapse, causing what is called "phantom tax,” where all the gains you’ve used up to that point on a tax-free basis are no longer protected by the policy (because it’s gone), and you get a massive 1099. Not awesome.
Today, this is hardly an issue. Most LIRPs have what is called an "over-loan protection rider” that prevents you from lapsing your policy in this manner. It is free and a standard feature. So, this concern is largely something of the past.
Caps, Participation Rates, Spreads, and Enhancements
In choosing an insurance company to open your LIRP with, it is important to investigate the history of the renewal rate with respect to caps, participation rates, and enhancements (if they offer any).
Cap rates can and do change. They are raised and lowered depending on several economic factors. Most companies have lowered cap rates as times go on, but very few have actually raised them as well. You will want to make sure that the company you choose has a good renewal history on this front.
Likewise, participation rates can change as well. For example, a high par focus strategy might have a current par rate of 130% (providing you 130% of whatever the S&P 500 does in a year subject to a cap). The next year, due poor economic conditions, the insurance company might feel it necessary, in order to continue to guarantee your money (the primary focus) to lower the par rate to 120%. However, a few years later, due to favorable economic conditions, the par rate is raised to 150%. We have seen this type of movement regularly.
Spread rates do not often change as much. For whatever reason, this type of index-based strategy is not used a lot. However, it has tremendous potential and should not be overlooked. Indeed, over the past many years of historically low interest rates, cap rates have fallen as a general rule (though they will likely rise in the future). However, during that time, the spread strategies have fared better. This does not mean this will always be the case, but it is worthy of note and one reason why diversifying among differing index-based strategies inside your tax-free allocation is wise.
Using Funds Too Early or Aggressively
This is the the flip side of the "Underfunding" caution above. Generally speaking, LIRPs need time to cook, at least ten years, some significantly longer. Accessing the values too early can be akin to taking a cake out of the oven too early--it turns into a tortilla. This is a misuse. While the liquidity may be there, early access should only be used for emergencies or shot-term tactical plays. The policy is simply not mature enough yet.
Often times when people complain about a LIRP's performance, I learn that they have hamstrung the policy by a serious deviation from the original structure and plan. Sometimes life happens, but serious caution should be had in determining to use funds from a LIRP much earlier than planned or taking distributions too aggressively, no matter how much time has passed. We're not making a quick sandwich here, but a sumptuous potroast. Give it the time it needs.
There are versions that have more liquidity up front, which may be appropriate in some circumstances, but those usually come with a little bit higher fees later.
You have no doubt caught on that health can be a deciding factor in the effectiveness of a LIRP in your situation. You must be able to pass an insurance exam in order to qualify for a LIRP. However, you do not have to be able to do 100 pull-ups or run the mile in 6 minutes. Superman health is not required. Many people with regular health situations that naturally develop with age still qualify just fine. If you are unsure, speak with a tax-free retirement planner and find out. It’s free to talk, right?
If your health is prohibitive for whatever reason, that doesn’t necessarily disqualify you from owning a LIRP. The insurance death benefit can be assigned to anyone you have “insurable interest” on, such as a spouse, children, or parents. Your best friend who is unrelated to you does not count as insurance interest.
So, you can own the LIRP with all of its tax advantages, assign the death benefit to be on your healthy adult child (or minor children), and you’re in business. The disadvantage of this is that your passing away doesn’t trigger the death benefit payout, but you still have all the tax-free growth and income, all the tax-free index-based allocation options, and complete control over the money. We have used this many times in our practice when necessary, opening the doors of this tax-free vehicle to those who otherwise would not qualify for it.
Choosing a LIRP Company
There are essentially three different types of insurance companies:
- Stock companies (private or publicly traded)
- Employee-owned companies
- Mutual companies
A stock insurance company is owned by shareholders, whether publicly traded or held privately. In either case, the leadership of the company has a duty (a mandate, even) to do what is in the best interest of the shareholders or owners. With a stock insurance company, the shareholders/owners are not the policyholders. Often times, in trying to maximize profits or stock prices (or to appease Wall Street), decisions to that end can adversely affect policyholders (you). This can happen in the form of increased fees, lower caps or participation rates, or combinations of both. While it is not uncommon to find stock companies treating their clients fairly and with good track records, it is more likely that decisions that can adversely affect clients occur with a stock insurance company.
An employee-owned insurance company is technically still a form of a stock company, but with a twist. The employees own a large portion (even a majority) of the company. This makes their incentives to serve clients and ensure they are taken care of more than just their paycheck. The profitability of their company, which they hope translates to higher value of their ownership in the company, depends on happy, long-term clients. This can help place the clients’ interests and company’s interests in better alignment. Also, because the company is not publicly traded, it is not beholden to Wall Street and the pressures to meet analysts predictions.
A mutual insurance company is generally our favorite. Like a stock company, the leadership has a duty to do what is in the best interests of the owners. In this case, the owners are the policyholders. In other words, the leadership has a duty to maximize profits for the policyholders. Talk about alignment of values. These profit maximization tools often show up in the form of decreased fees, competitive cap and participate rate renewals, no old-money-new-money practices, and flexible liquidity provisions. Indeed, many mutual companies lower the costs of insurance for existing and new clients every chance they get. This is because they know that their owners, the policyholders, will be more profitable by doing such.
While any of these 3 types of companies may serve well, depending on your objectives and situation, it is more likely that you will have the best experience with a mutual company. That said, we have used all 3 types of LIRP companies for different clients, all to good results.
A Life Insurance Retirement Plan has a many things to offer. No, we do not love life insurance, we love tax-free. We love the features it can offer. Don't judge things by thei names but by what they can do. As part of a well-rounded retirement strategy, ia LIRP can potentially be a critical piece to the success of that strategy.
The advantages are numerous, but a final list might be instructive for those giving serious consideration:
- No contribution limits (you define them)
- Tax-free access at any age
- No IRS age restrictions
- No forced usage (RMDs)
- Tax-free term insurance death benefit above and beyond account values
- Tax-free long-term care provisions
- Potentially competitive market-style returns
- Annual lock in of gains
- Protection/floor against market losses
- Distributions do not count as Provisional Income, therefore do not cause you social security income to become unnecessarily tainted by taxes
- No earned income required in order to contribute
- No income phase-outs (anyone can own one)
- Creditor protection (we didn’t spend time on this, but check your state laws)
In the end, we can sum it up thusly: A properly structured LIRP has the ability to offer Safety, Liquidity, Tax-free Rates of Return, and a Low Fee Structure.
We warned part 4 would be more technical and dense :)
Concerned about the future of taxes in your retirement outlook? Talk to us. We'd bet we can help.
Kristen Cooper, NSSA®
Axios Capital Strategies