Taking action to position your clients’ wealth for a rising tax environment has never been more urgent. Whether you are a financial advisor or a CPA, now is the time to expand the conversation with your high-net-worth clients to move beyond rate of return and include the notable tax advantages of overfunded life insurance.

The current U.S. tax environment has pushed tax mitigation strategies to critical importance for affluent clients seeking to preserve wealth in the future. Following an era of historically low taxes, there is nowhere for tax rates to go but up. Prior to the Covid-19 pandemic, the U.S. was already facing a mounting level of national debt, totaling $22.8 trillion at the end of 2019. The pandemic further exacerbated the situation, adding trillions more in Covid-related relief. The most recent bill that was passed in March 2021 added another $1.9 trillion to the tally.

Such debt puts our nation at financial risk, and one of the simplest ways for the government to reduce the debt and its inherent risk is to increase taxes.

The 2017 Tax Cuts and Jobs Act isn’t set to expire until 2026, but lawmakers may opt to hike taxes sooner. Even if a change in the tax rate is delayed, rates are expected to increase over the coming decades. At the same time, the current political climate suggests that those who are likely to shoulder the brunt of new taxes are individuals with higher incomes and greater accumulated assets. In short, your high-net-worth clients need a strategy to hedge rising taxes—now.

Taking steps to protect against rising taxes is not a novel concept. For high earners, the two most common strategies are:
1. Investing in Roth 401(k)s and Roth conversions.
2. Investing in managed portfolios in health savings accounts (HSAs).

Unfortunately, both of these options are plagued by contribution caps. For clients that have the means to invest more and who are focused on mitigating taxes in retirement, overfunded life insurance offers a valuable third option. At the most basic level, life insurance provides a death benefit to the policyholder’s beneficiaries. When properly designed, however, a permanent life insurance can be transformed into an alternative investment vehicle that offers an income tax-free death benefit and tax-free growth for the cash value of the policy. Thanks to recent changes in the tax law, this option may be more attractive than ever.

Tax-Law Changes Increase The Investment Power Of Life Insurance
In 1984, Section 7702 of the tax code imposed an interest-rate floor of 4% on all permanent life policies with the intent of limiting the tax-shelter advantages of cash-value policies. Notably, Congress amended the code in late 2020, reducing the tax-code interest rate to 2% as of January 1, 2021. The change was a major win for life insurance carriers whose margins had been virtually erased amid an ultra-low-interest-rate environment. The biggest winners of all, however, may be high-net-worth investors who can now add overfunded life insurance to their portfolios as an additional and powerful tool to help reduce the impact of rising taxes on their wealth.

For business owners and other high-net-worth investors, Variable universal life policies (VULs) offer particularly strong advantages, including the flexibility to invest the full cash value of a policy; greater growth potential than traditional cash value or whole life insurance policies; and, thanks to the amendment to Section 7702, flexible premiums that allow the purchase of the lowest possible death benefit at the highest allowable premium. For highly conservative affluent investors who are willing to give up some level of growth in exchange for the relative safety of a more predictable rate of return, fixed-rate universal life policies (ULs) and indexed universal life policies (IULs) also offer tax-savings opportunities.

Navigating The Client Conversation
Like most investment options, overfunding isn’t appropriate for every investor. Clients most likely to be suitable for this strategy are investors in reasonably good health who are dedicated to asset growth and are focused on protecting their wealth in a rising tax environment, as well as small business owners who do not want to implement a qualified pension plan or want to save more than their qualified plan allows. To introduce these high-net-worth clients to the advantages of overfunding permanent life insurance, the following points may help clarify the value of this strategy:

• Efficient retirement tool: Traditional IRAs and qualified plans offer tax-free growth, but they are taxable at distribution. In contrast, permanent life policies offer tax-free growth and a tax-free income stream at retirement, providing high-net-worth investors benefits that parallel those of Roth IRAs, but without the income limitations. By balancing tax-deferred and tax-preferred options, investors can create a more tax-efficient retirement income stream.

• Tax-favored growth: As tax rates rise, the value of every dollar in your investment portfolio falls, making income tax-deferred investment options a critical component of retirement planning. Returns on permanent life policies grow untaxed and, when properly structured, may be accessed untaxed, and provide an income tax-free death benefit.

• Greater growth potential: VULs are structured to allow the cash value of the policy to be invested in actively managed subaccounts that mirror mutual funds. Like many 401(k)s, the investment options available are vast, providing opportunities for greater diversification and long-term growth. With a long-term average rate of return between 6% and 8% (net of costs and fees), VULs benefit from the strength of the market.

• Funding flexibility: Unlike vehicles such as Traditional IRAs, Roth IRAs, Qualified Plans, and HSAs, there are no contribution limits on permanent life policies, as long as each policy complies with TEFRA/DEFRA regulations. Thanks to recent changes in the law (Section 7702), the allowable amount that can be contributed to the savings component of these policies has been increased as of January 1, 2021. This makes overfunded life insurance more attractive for affluent investors and small business owners in need of an additional tax-mitigation strategy.

• Asset protection: In contrast to trusts and other investment vehicles, principal held in permanent life policies is fully protected from any legal claims by creditors. And unlike domestic asset-protection trusts that require the assistance of an attorney and charge an annual asset management fee, they can be structured by a licensed life insurance professional at a much lower cost. In addition, policy principal does not reduce your Social Security and Medicare benefits, and death benefits are distributed tax-free.

• Penalty-free distribution prior to age 59½:  Permanent life policies offer near-immediate access to assets with no tax penalty. This tax-free liquidity is particularly valuable in the event of a disability, to fund early retirement, or to fund personal and business expenditures. Policies can also be structured to offer policyholders the option to buy property, cars, and other large purchases from themselves while retaining unlimited access to policy principal.

In light of the national debt escalation combined with the economic impact of the Covid-19 pandemic, it seems unlikely that tax rates will remain low in the future—especially for high-net worth clients. As a result, it is important to put a strategy in place to help mitigate taxes on distributions from pre-tax accounts in retirement. 

Speak to your clients now about the tax-mitigation potential of overfunded life insurance. For those that are interested, proper design is essential to ensure efficient growth of the policy’s cash value. If you don’t have detailed knowledge in this area, it is important to work with an independent and licensed life insurance professional (CLU, ChFC, CFP) who understands the complexity and features of permanent life insurance contracts, as well as applicable IRS tax rules (TEFRA and DEFRA).

Gary A Borowiec, CLU, ChFC, RFC, LUTCF, CLTC, RICP is managing partner of Madison & Main Advisors, an independent planning firm based in Madison, NJ. An independently owned and operated Member Firm of M Financial Group, Madison & Main specializes in investment tax planning and wealth transfer.