If you advise clients to purchase max-funded life insurance policies (just short of a MEC) with the intention to access those values to supplement retirement cash flow, you have four choices in how that can occur, all of which are governed by IRC Section 72:

1. Annuitize the cash value.  This eliminates the policy death benefit.  A portion of each annuity payment is considered a return of the cost basis of the policy and is not taxable.  Once cost basis is recovered all payments are taxable.
2. Withdraw funds from the policy.  Withdrawals in excess of cost basis are taxable.
3. Withdrawals up to cost basis; loans thereafter.  Withdrawals are tax free.  Loans are tax free provided the policy stays in force.
4. Loans from the policy.  Loans are tax free provided the policy stays in force.

#3 and #4 include a growing tax bomb once loans begin. ?This is relatively easy to deal with initially, but over time, it can create a serious financial problem for the uninformed client if the policy is surrendered or lapsed.

Example:
Assumptions (at time of surrender or lapse at an advanced age):

• Cumulative premiums paid are $250,000 (the cost basis).
• Policy gross cash value is $1,000,000.
• Policy net cash value is $100,000 (after deducting a loan balance of $900,000).
• If the policy is surrendered or lapsed, the taxable gain is $750,000 ($1,000,000 - $250,000). ?Likely all (or certainly most) of it will be taxed at 45% or more.
• 45% of $750,000 is $337,500.
• The net cash surrender value is $100,000 leaving your client short $237,500 of the taxes due ($337,500 - $100,000).

This is not a pretty picture.

The safest method of accessing cash from the policy is #1 (annuitize) or #2 (withdrawals). ?Both result in taxable income, but the potential tax bomb (taxes due with insufficient residual cash value to pay the tax) is avoided.

#3 has typically been a good choice for all tax free cash flow (tax free withdrawals to basis followed by tax free loans). ?This reduces the amount of loans which correspondingly reduces the potential tax bomb.

Participating loans (loans that continue to earn whatever interest is credited to the policy) has changed the preference for many to #4 (loans only) but increases the potential tax bomb.  The risk is reduced if there is a guaranteed loan interest rate.

With #3 or #4, the tax bomb can be avoided if the policy is neither surrendered nor allowed to lapse, since the policy death benefit wipes away the income tax liability. ?The foundation of this special treatment is IRC Section 101. ?This statute provides that the proceeds of life insurance maturing as a death claim are exempt from federal income tax.  This applies to the full death benefit, including any cash value component whether loans exist or not.

A lurking tax bomb can be present in all forms of whole life and universal life where policy loans are utilized.  It can be avoided, and you, the producer, are key to making sure your clients are aware of how to sidestep it.

Can your clients remember these facts years into the future? ?If they are incapacitated, will family members understand the issues? ?It is probably best to attach a short note to the policy -- something like this (although your compliance officer will likely have preferred language):

If/when you take policy loans on this policy, be sure to talk to your financial adviser before surrendering or lapsing the policy in order to anticipate unexpected tax consequences that may otherwise be avoided.

Does that note on the policy make it hard or easy to deliver the policy?  It’s very hard if you haven’t discussed it with your client; very easy if you have. ?And that’s the point -- it should be discussed.

It is best if you design the policy illustration with no premiums due after retirement if loans are anticipated in retirement years. ?An in-force policy with no premiums scheduled is much more tolerable at advanced ages than one with continuous premiums.

A small handful of life insurance companies have concierge units that monitor loan status at the point of lapse or surrender. ?To be effective regarding the tax bomb, they need to be proactive in their client relationships, not merely reactive to client inquiries.  I hope that ultimately the policyholder service division of all life insurance companies will bring this potential liability to the attention of those surrendering or lapsing policies, particularly those policies with 50% or more of the gross cash value subject to outstanding loans.  I also hope that any such policies issued with lapse supported pricing do not produce “let ‘em lapse” directions from senior management.

Next week, I’ll show you a mathematical comparison between fixed and participating loans on the same indexed universal life policy. ?The difference is significant.

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Important Note:  This information in this Blog is for educational purposes only. ?In all cases, the approval of a client’s legal and tax advisers must be secured regarding the implementation or modification of any planning technique as well as the applicability and consequences of new cases, rulings, or legislation upon existing or impending plans.