When the subject of income planning arises in advisor-client engagements, many advisors do not realize that cash value life insurance can play a valued role in the plan.
"Permanent life insurance is perfect for income planning purposes," says David Anderson, a chartered financial consultant and a director of development at the Wyoming General Office of New York Life, Casper, Wyo. "This is in part because of the product's preferential tax treatment."
A policyowner, he adds, can borrow or withdraw against a permanent life policy up to basis (total premium payments minus outstanding loans, etc.) without incurring income or capital gains tax. What is more, values grow inside the policy tax-deferred, while death benefits come out tax-free.
Another big benefit: when policyowners retire their outstanding policy loans, sources say, they are in effect paying themselves back, recapitalizing the cash value they own.
Permanent life insurance can also be used to complement a straight life income annuity. Here, the client enjoys the maximum payout allowable on the annuity, and when income distributions discontinue at death, the life insurance policy will provide a death benefit to surviving beneficiaries.
This option may be preferable to buying a period certain immediate annuity, experts say. Such annuities guarantee a death benefit for a surviving beneficiary during the specified period, they allow, but they pay an income stream to the annuitant that is reduced in comparison to income paid out by lifetime immediate annuities.
For many clients, the income planning benefits of participating life policy issued by mutual insurance companies are particularly attractive, say sources. The reason: dividends issued to policyholders can, among other options, be used to purchase additional, paid-up insurance. These dividends–a return of premium to the policyowner–provide additional cash value against which to make withdrawals without having to resort to an interest-bearing loan. [Note: Not all life policies allow withdrawals.]
Alternatively, experts say, the dividends can be applied against policy premiums. At a certain point in the life of the contract, the accumulated dividends will pay for the policy, thus freeing up cash for retirement income.
"I will always recommend that clients surrender the dividend build-up before taking out a loan from a policy," says Steven Spiro, a national director and past president of the Independent Insurance Agents and Brokers of New York (IIABNY) and president of Spiro Risk Management, Valley Stream, N.Y. "If clients surrender some dividends to get the cash they need, there are no tax ramifications and no interest due."
Should clients need to borrow against a participating policy's cash value beyond the accumulated dividends, however, then they need to be mindful of the fact that loans are treated differently from contract to contract.
Direct recognition policies, sources say, not only tack an interest charge onto the loan, but also reduce future dividends. Under direct recognition, in effect, the more one borrows the less the policy earns.
"This is why I favor participating policies that do not offer recognition dividends," says Herbert Daroff, a certified financial planner and partner at Baystate Financial Planning, Boston, Mass. "With these contracts, you get the same dividend scale whether you borrow or not. So you have a better distribution policy because you're not penalized for taking the money out."
