A Gift You Do Not Want to Unwrap

I recently received the following question from a Certified Public Accountant. It was a question posed to him by a client in their year-end planning meeting.

“We were reviewing our life insurance needs, and the insurance agent suggested that we consider investing more of our reserves into a life insurance contract. Presently, we have $100,000 invested with Fidelity. The insurance agent’s argument was: one, investing in a life insurance contract would guarantee at least a 1% return even during bad market years (maximum earnings capped at 13.5%); and two, you do not have to pay taxes when money is withdrawn from a life insurance contract.

We like the idea of at least a 1% return during bad years and tax sheltered growth. I’ve read that a disadvantage of this idea is the higher rate of costs associated with managing these equity-indexed accounts in a life insurance contract. Fidelity charges me about 1% if I remember correctly.

In your opinion, is investing in a life insurance contract a good idea? Are there disadvantages that we are not considering?”

Let’s see, as I understand the question, the insurance agent is suggesting that the client should sell securities held at Fidelity and invest the proceeds in an indexed universal life insurance contract.

If the insurance agent is also registered with the Financial Industry Regulatory Authority (FINRA), the agent may be “selling away.” Selling away is making a recommendation to purchase or sell a security not held at the representative’s broker-dealer. All of this leads me to my next observation: absent any other facts and circumstances, the agent is behaving in an unethical manner and may be in violation of your state’s insurance regulations.

Let’s see what is being recommended:

1) Investing in a life insurance contract would guarantee at least a 1% return even during bad market years (maximum earnings capped at 13.5%). The agent either omitted, or did not clearly communicate to the client, that the “guarantee” will be net of policy fees, expenses and mortality charges. Factually, the guarantee is something less than 1%.

2) You do not have to pay taxes when money is withdrawn from a life insurance contract. This is an interesting statement, and again, a factual misrepresentation (I am beginning to see a consistent theme with the insurance agent). Yes, withdrawals up to basis in a life insurance contract are income tax free.  It is the ‘up to basis’ which was left out of the agent’s presentation that is critical to the client’s the decision.

If the life insurance contract has earnings in excess of premiums paid, then the withdrawals are taxed as ordinary income. If the money had been left at Fidelity then the taxation would have been long-term capital gains and not ordinary income. So the life insurance agent is saying: sell your securities and pay long term capital gains tax in order to “invest” those funds into a life insurance contract in order to pay ordinary income tax rates when you access them in the future. The transaction appears to be one-sided.

All of this being said, a whole life insurance contract may be used to hold a family’s emergency reserve bucket, which could include three to six months of living expenses based on facts and circumstances. There are a few nuances but they are not pertinent to this response.

I hope you will join me on this month’s CE/CPE Webcast: Year End Tax Planning on Friday December 20, 2013 at 1:30PM EST. This Webcast will provide an overview of the key changes within the tax laws for 2013. We will cover new tax provisions to watch for as well as how the tax law changes will affect tax planning for our clients. The presentation is web based and virtual seating is limited. The course is approved for one hour of CPE and CE. For more information or to register, please send an email to hello@ttillery.com.

 

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