Let us begin with some historical background on Life Insurance. Life Insurance has three main benefits:
1) Tax Free Death Benefit.
2) Tax free growth of the assets inside the policy.
3) Tax free income when you pull money out of the policy.
The main reason younger individuals (age 20 to 55) purchased Life Insurance is the need to have a large amount of liquidity (Death Benefit) available to fulfill any financial commitments upon premature death. As individuals become older and no longer have those financial commitments, the advantage of having a place where investments could grow without the friction (anything that erodes the true return of an investment) of taxes becomes a very important tool in their portfolio. Traditionally, US Life Insurance Companies structure the policies in a way to dilute the benefits of the tax-free growth to maximize their profits.
Eventually clients began asking for Life Insurance policy structures that maximized the net tax-free growth of the assets inside the policy and dramatically minimized the cost structure, thus lowering the profit to the Insurance Company. This has led to the creation of “Custom Design” Life Insurance Policies. By Custom Designing these polices it is possible to reduce the friction on the asset growth inside the policies by as much as 90%.
Life insurance Companies make their money from two main sources:
1) They buy Death Benefit from re-insurers at wholesale and sell that Death Benefit to their policy holders at retail, thus the more "Death Benefit" they can sell the more money they make.
2) They restrict where, you as the policy holder, can invest your money by controlling the management fees charged by the Investment Managers and getting a "rebate" of those management fees.
In Custom Designed policy structures these two factors are controlled or mitigated. The life policies are built with only enough death benefit to satisfy the tax law that governs this kind of Insurance and the policy allows the policy holder to invest in virtually ANY asset. Today one can negotiate with a life insurance company to pay a flat percentage of the assets inside the policy and as a result I keep the costs of the structures very close to the cost of managing the same assets outside of the policy. It all boils down to the cost of tax vs. the cost charged by the insurance company. Typically, the structure cost about 25% of what the tax would be on the growth of that same asset.
Example, a client has a brokerage account with a value of $1,000,000, a real estate property valued of $1,000,000 and interest in an operating business valued at $1,000,000. Let us assume that the average growth of the brokerage account at 10%, the real property at 8% and the income from the operating business at 14% of value or an average of 10.67%. This would result in a yearly taxable growth of $320.000. Let us further assume that between the ordinary income tax of 35% and the capital gain tax of 20%, therefore the average tax rate would be 28%. These assets outside of the Life Policy would generate a tax of $89,000 ($320K X 28%). These same assets inside a Life policy would generate $0 tax, due to the fact that Insurance Companies are taxed under a different section of the IRS code that normal persons or businesses, thus the cost (friction) would be the insurance charges from the Insurance Company. Typically, this cost would be about $22,000 or result in a savings of $67,000. In other words, the net friction of the investment is reduced by 75%. Compound that over a few years and the result is quite significant.
Summary: would you rather pay $89,000 in taxes or $22,000 in insurance costs?
When custom structures are designed properly, the policy is set up to accept assets as the "Premium". This means that in the above example, the client does not have to liquidate the brokerage account, sell the real estate, and sell the operating business or place cash into the structure and then repurchase the asset. The name of the owner of each asset is simply changed from the owner’s name to the name of the owner’s new Life policy. This is called an "In-kind Premium".
The only downside to this process is that at the time the name of the owner is changed, the IRS classifies this as a "deemed sale" and the owner would recognize any gain in the value at the time of transfer, compared to the original purchase price. This normally results in a tax due at the time of the transfer. For example, let us say the client bought the stock in a brokerage account (example above) for $500,000 and the value at the time of transfer is the above $1,000,000. At the time of transfer the client would have to pay tax on the $500K of growth even though they had not literally sold the assets. Of course, once that tax is paid and the asset is placed inside the policy, any growth of that asset is never taxed again, ever!!! Let us say that the brokerage portfolio grows to $10M over the next 10 to 15 years. The addition $9M would not have any tax due, both at the time of growth and at the time that those assets are pulled out of the Life Policy for the client’s consumption. So, you must ask yourself if you are willing to pay some tax on your gains now, to save a bunch of tax down the road. To mitigate this transfer tax we have a strategy we use to defer the tax on appreciated assets for up to 30 years (https://www.privateclientadvisers.com/enhanced-opportunity-fund.html). We call this strategy "The Holy Grail" because it allows our clients to place tax deferred dollars into a Custom Designed Life Structure, let it grow tax free and then consume it free of taxes through the use of policy loans.
1) Tax Free Death Benefit.
2) Tax free growth of the assets inside the policy.
3) Tax free income when you pull money out of the policy.
The main reason younger individuals (age 20 to 55) purchased Life Insurance is the need to have a large amount of liquidity (Death Benefit) available to fulfill any financial commitments upon premature death. As individuals become older and no longer have those financial commitments, the advantage of having a place where investments could grow without the friction (anything that erodes the true return of an investment) of taxes becomes a very important tool in their portfolio. Traditionally, US Life Insurance Companies structure the policies in a way to dilute the benefits of the tax-free growth to maximize their profits.
Eventually clients began asking for Life Insurance policy structures that maximized the net tax-free growth of the assets inside the policy and dramatically minimized the cost structure, thus lowering the profit to the Insurance Company. This has led to the creation of “Custom Design” Life Insurance Policies. By Custom Designing these polices it is possible to reduce the friction on the asset growth inside the policies by as much as 90%.
Life insurance Companies make their money from two main sources:
1) They buy Death Benefit from re-insurers at wholesale and sell that Death Benefit to their policy holders at retail, thus the more "Death Benefit" they can sell the more money they make.
2) They restrict where, you as the policy holder, can invest your money by controlling the management fees charged by the Investment Managers and getting a "rebate" of those management fees.
In Custom Designed policy structures these two factors are controlled or mitigated. The life policies are built with only enough death benefit to satisfy the tax law that governs this kind of Insurance and the policy allows the policy holder to invest in virtually ANY asset. Today one can negotiate with a life insurance company to pay a flat percentage of the assets inside the policy and as a result I keep the costs of the structures very close to the cost of managing the same assets outside of the policy. It all boils down to the cost of tax vs. the cost charged by the insurance company. Typically, the structure cost about 25% of what the tax would be on the growth of that same asset.
Example, a client has a brokerage account with a value of $1,000,000, a real estate property valued of $1,000,000 and interest in an operating business valued at $1,000,000. Let us assume that the average growth of the brokerage account at 10%, the real property at 8% and the income from the operating business at 14% of value or an average of 10.67%. This would result in a yearly taxable growth of $320.000. Let us further assume that between the ordinary income tax of 35% and the capital gain tax of 20%, therefore the average tax rate would be 28%. These assets outside of the Life Policy would generate a tax of $89,000 ($320K X 28%). These same assets inside a Life policy would generate $0 tax, due to the fact that Insurance Companies are taxed under a different section of the IRS code that normal persons or businesses, thus the cost (friction) would be the insurance charges from the Insurance Company. Typically, this cost would be about $22,000 or result in a savings of $67,000. In other words, the net friction of the investment is reduced by 75%. Compound that over a few years and the result is quite significant.
Summary: would you rather pay $89,000 in taxes or $22,000 in insurance costs?
When custom structures are designed properly, the policy is set up to accept assets as the "Premium". This means that in the above example, the client does not have to liquidate the brokerage account, sell the real estate, and sell the operating business or place cash into the structure and then repurchase the asset. The name of the owner of each asset is simply changed from the owner’s name to the name of the owner’s new Life policy. This is called an "In-kind Premium".
The only downside to this process is that at the time the name of the owner is changed, the IRS classifies this as a "deemed sale" and the owner would recognize any gain in the value at the time of transfer, compared to the original purchase price. This normally results in a tax due at the time of the transfer. For example, let us say the client bought the stock in a brokerage account (example above) for $500,000 and the value at the time of transfer is the above $1,000,000. At the time of transfer the client would have to pay tax on the $500K of growth even though they had not literally sold the assets. Of course, once that tax is paid and the asset is placed inside the policy, any growth of that asset is never taxed again, ever!!! Let us say that the brokerage portfolio grows to $10M over the next 10 to 15 years. The addition $9M would not have any tax due, both at the time of growth and at the time that those assets are pulled out of the Life Policy for the client’s consumption. So, you must ask yourself if you are willing to pay some tax on your gains now, to save a bunch of tax down the road. To mitigate this transfer tax we have a strategy we use to defer the tax on appreciated assets for up to 30 years (https://www.privateclientadvisers.com/enhanced-opportunity-fund.html). We call this strategy "The Holy Grail" because it allows our clients to place tax deferred dollars into a Custom Designed Life Structure, let it grow tax free and then consume it free of taxes through the use of policy loans.
|
|