Indexed Universal Life insurance
Indexed universal life (IUL) insurance policies are cash value policies that can be allocated into a fixed interest or equity index account. Since the cash value accumulates tax free over time based on an equity index, these policies are not unlike traditional retirement vehicles like Roth IRAs. The added benefit is that there are no contribution limits to these policies that may make them a great option for high-net-worth individuals. In this article, we’ll take a look at the many tax advantages associated with IUL policies and how they can be used as a part of a retirement strategy.
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Tax Deferred Growth
Indexed universal life account values grow on a tax-deferred basis, which means that policyholders can benefit from triple compounding. This means they earn interest on the principal, interest on the interest, and interest on the money that would have gone toward taxes. For example, suppose that you invest $10,000 in a mutual fund that grows at 5% per year over the next 20 years. The sale of the mutual fund would generate $26,533 in capital gains and $3,978 in taxes at a 15% tax rate. The same $10,000 invested in an IUL policy would result in potentially higher gains (no losses during down years) without any taxes, since the policyholder would simply take out a “loan” from the policy rather than a distribution.
No Contribution Limits
Indexed universal life policies have no limitations on annual contributions. By comparison, individuals under 50 may only contribute $5,500 per year to an IRA, while those over 50 may only contribute $6,500, which may not be enough for their retirement. For example, suppose that you start investing late in life at age at age 50 and max out a Roth IRA over the next 10 years. A 5% annual return would yield an account value of approximately $81,756 over that time-frame, which isn’t enough to finance a full retirement. The same person could contribute a lump sum of $65,000 in year one at the same market return and make $105,878 over the time-frame due to the effects of compounding.
The cash value in indexed universal life policies can be accessed at any time without penalty regardless of a person’s age. By comparison, those taking money out of a Roth IRA before age 59 ½ are subject to a 10% penalty and must pay ordinary tax on the income. For example, suppose that you require $25,000 before the age of 59½. Taking the money from a Roth IRA would result in $2,500 in penalties and an additional $7,500 in income tax at a 30% tax bracket, whereas the same $25,000 could be loaned from an IUL policy tax and penalty free.
Better for Heirs
Indexed universal life policies are not subject to income or death taxes, while they sidestep probate and go directly to the named beneficiaries. The same cannot be said for other retirement assets that may be subject to these taxes and a lengthy probate process. For example, those with multi million dollar estates may be subject to a 40% tax rate on assets above $5.43 million as well as state estate taxes. IUL policies are not subject to these taxes and can help lower a person’s total asset base or at least exclude the policy amount.
Indexed universal life policies purchase call options on equity indexes to gain exposure to upside without the risk of downside. Since they aren’t actively managed, there are no year end distributions and returns may be higher than many actively-managed funds. According to Barron’s, on a ten-year basis ending in 2013, only 45% of active managers outperformed their benchmarks and most of them only did so by less than 1%. These dynamics suggest that passive investing may provide the best returns.
The Bottom Line
Indexed universal life insurance provides a number of tax benefits compared to traditional retirement accounts that investors should consider. In particular, high-net-worth individuals may find the greatest benefits from leveraging these tools as a part of a larger retirement tax strategy.
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