Questions about overfunding a universal life insurance policy

[Nords]

Here's a question for all you agents and insurance enthusiasts. Make a bathroom call, get a fresh cup of coffee, and settle in for a rockin' good time.

A shipmate is getting ready to retire after nearly 28 years. He may have been expecting the assignment officer to [-]ignore[/-] let him linger a little at his current duty station, or perhaps he was just hoping to negotiate a better set of orders. Regardless, the negotiations abruptly terminated and his last day in uniform is 1 April. (A three-year tour to the minute.) Ironic date to retire, yes, but it's only 77 days away.

No need to worry about him or his finances. He's always intended to work a bridge career and he'll probably land a job before he collects his first pension check.

However his financial acumen is another issue. He's never bothered to learn much about investing and he's still vulnerable to the siren songs of financial advisers & snake-oil salesmen. He's asked a question that I've only encountered once before, and I'm hoping to craft a better answer for next time. You know, in case someone asks me about it while I'm at a book-signing event or a retirement seminar.

Here it is:

... I received an interesting book a little while back called Tax-Free Retirement by Patrick Kelly. Any chance you have heard of it or read it? Bottom line is that he strongly advocates Universal Life Policy as an investment vehicle -- by overfunding it.
Example he uses is to overfund a $500k policy at to the tune of $1800/mo, and by age 65 (starting at 40), you have a policy with a cash value of $1.8M. I tried to calculate ROI, and got 7.45% -- and
that doesn't even decrement the investment by the cost of the insurance. Also, my whole life insurance has been getting well under 5% for awhile now. Anyway, regardless of whatever you can get your
cash value up to be, he goes on to explain that there would be tremendous value in having a super-sized life insurance policy, because then you can take money out for yourself, tax free, and the value would still keep growing. Best part is no death tax when you croak and your kids get whatever is left. So it does sound like an attractive option.

My response to him is below. Is there a website or a better rebuttal I could refer to? I'm not a Kelly fanboi, but I'm trying to put together a more compact critique of his scheme.

You're essentially turning your assets over to an insurance company in the hope that they'll find a way for you to avoid taxes. You could achieve the same result by paying a few thousand bucks to a CPA and a CFP who'd put you in tax-free municipal bonds and rental real estate-- but you'd pay a lot less money for better returns. (Of course you could also do tax-free munis and rental real estate on your own.) You could do your own tax-efficient portfolio by investing in the TSP and index mutual funds or ETFs with Vanguard (like their S&P500 index fund, VFIAX). You'd pay ridiculously low annual expenses (0.20%/year or less) and your taxes would be capital gains at rates of 0-15%. Again you'd achieve lower overall expenses (a little more in taxes but a lot less in insurance fees) and you'd get to keep the profits.

You'd have to try to compare Kelly's system to doing your own investing. I guess one way to put numbers on your own estimate would be to take that same $1800/month, figure out how much of it would go to your SBP premiums, and invest the rest in a Vanguard S&P500 index fund earning 3%/year over inflation. You could compare the UL policy to the SBP by assuming that the value of the UL policy would have to purchase a simgle-premium immediate annuity with a COLA that matches SBP payments and their COLA. See who has how much after 25 years.

The other side of the UL contract is the economy. Lots of insurance companies sold UL policies during the 1980s-90s bull markets at ridiculously low premiums and incredibly high assumptions of market returns. Then in 2001 their portfolio losses greatly exceeded the premium reserves and they started going after their insureds: "So sorry, market returns are sub-par and you need to make up the premium deficiency by putting more money into the policy."

You could look at it this way: If Kelly's claims worked for the majority of investors, then investment companies like Fidelity and Vanguard would be all over it. The reason it's not more popular might be because there are other investments which result in paying more taxes than Kelly's method, but with much higher returns for the investor and much lower expenses. In other words Kelly would be paying a lot to the insurance company to avoid paying cap gains taxes and estate taxes. I think you might be better off paying a little bit of taxes while keeping much higher investment gains.

What can I do to correct those points (if necessary) and come up with better ones?

 

[Koolau]

IIRC there are significant restrictions on this "investment" strategy - set by the IRS. I think you can only "overfund" by a set amount. No idea on the details, but this might be important for a potential "investor" to check out. I'm sure you are already up to date on this. I mention it as a "negative" to the whole idea. Any time the IRS shows interest in what you are investing in and how (before you actually make any money) - that's a negative in my book. YMMV

 

[kaneohe]

Nords, don't know your answer but I was tempted by the 5% being offered by my group UL so I tiptoed in, aware of the MEC limit mentioned by Koolau. The MEC limit was quite high (in terms of a lump sum) as I had had the policy for quite a while while working and did not really limit me in a practical sense. I did this despite a 2% premium tax (basically a one-time load). The caution on some other boards was to be sure I wanted/needed the insurance and to compare the cost with straight term to make sure some of the extra return wasn't subsidized by me. I did have a 5 yr term policy to compare with and
while it was true that the UL cost more, it seemed like if I put more into the UL, the variable return would be significant since the extra cost was a fixed amount and the cash added would keep increasing the return. It got even more tempting when the 2% fee was dropped (I think the strategy was that they raised the insurance rates for everyone so that those who didn't add cash subsidized those who did so they could market the cash accumulation fund as no load). Eventually I got out and terminated the policy because I wasn't comfortable w/ how their explanations of how/when interest was calculated and had worries about getting the funds back out. Also the premiums are tiered for 5 yr age groups and I was facing a big increase in a year.
However the return of funds was very uneventful and went very well so perhaps my
worries were unjustified and the analysis still suggests to me that esp w/ no load,
that the returns were pretty good esp for these days......and tax free, to my knowledge.

 

[pb4uski]

I doubt that any UL policy issued today would generate a 7.45% annual return, particularly after cost of insurance and expense charges. My guess would be that UL crediting rates are probably more in the 4% range for policies currently being issued and then deduct out COI and expense charges.

The other issue that I have for your friend's situation is does he need the insurance? If not, then the cost of insurance charges are wasted money.

The advantages of the UL policy are that the interest credited isn't subject to tax until he withdraws it, he can borrow against the policy, and the life insurance coverage if he needs it. The crediting rate of the UL policy will change over time as investment yields rise and fall, subject to competitive pressures.

If the issue is how to invest his nestegg, I think a low cost, diversified mutual fund portfolio in a tax advantaged account is preferable to a UL contract, particularly if he doesn't need the insurance coverage (for example, no family or dependents).

 

[urn2bfree]

I am not sure a out the Tax free part of this.. It grows tax free BUT when he takes the money out isn't it taxed as interest which is taxed not at cap gains rates but as regular income? I don't know, but there are definitely taxes of some sort due when money is taken out. Also I am not clear on how you take out "part" of it... Wouldn't you have to cash out the whole thing? That is going to potentially even increase the tax bracket.

 

[kaneohe]

I am not sure a out the Tax free part of this.. It grows tax free BUT when he takes the money out isn't it taxed as interest which is taxed not at cap gains rates but as regular income? I don't know, but there are definitely taxes of some sort due when money is taken out. Also I am not clear on how you take out "part" of it... Wouldn't you have to cash out the whole thing? That is going to potentially even increase the tax bracket.

this, from here LIFE INSURANCE 101 - First Choice Insurance, is my impression (if you are under the MEC limit)

Q: Do I have to pay taxes on the money I take out of my whole life or universal life insurance policy?
A: Generally, you may withdraw cash from your policy, up to the amount of premium you paid, without incurring any taxes under current tax law. However, any withdrawals over your premium payments would be taxable to you as income.

 

[pb4uski]

I am not sure a out the Tax free part of this.. It grows tax free BUT when he takes the money out isn't it taxed as interest which is taxed not at cap gains rates but as regular income? I don't know, but there are definitely taxes of some sort due when money is taken out. Also I am not clear on how you take out "part" of it... Wouldn't you have to cash out the whole thing? That is going to potentially even increase the tax bracket.

The "interest" is tax deferred if you take it out but tax free if you die since it is paid out as a death benefit.

You can take out part of it and it reduces your basis IIRC. So withdrawals would be tax free up to the amount of premiums that were paid but any amount withdrawn in excess of premiums paid would be taxable.

That my recollection anyway.

 

[Brett_Cameron]

I took out a universal life policy in 1982 for face value $200,000. They showed me printouts of projections at different interest rates of what the cash value would be if I stayed the course. It was downright dazzling!

I was paying $160/month premium. The insurance company took $32 off that and kept it (premium load). Cost of insurance at that time was $31.55 per month. Net increase in cash value was ~$70 per month which included ~$8 interest on cash value of $1300 (initial premium).

After about 5 years the "premium load" dropped to 5% of gross premiums paid and stayed there until 2011 when I cashed out.

In 1996 I reduced the premiums to match the cost of insurance at that time and let it ride.

Along about 1999, they stopped telling me what the maximum premiums I could pay were. The last time they told me I had put in ~$21,000 in premiums and the maximum allowed premium was ~$26,000.

It took me 14 years before the cash value exceeded the sum of premiums paid.

Needless to say, I learned a lot from this policy. Over the years, I took out two loans and paid it back in a few months (VERY EXPENSIVE) and made two partial withdrawals of cash value.

Interest rates paid on the cash value over the 29 years I had it varied from 4.5% to 6.15%.

I cashed it in just before FIRE. The insurance premiums were starting to go up exponentially as I aged and would have in a few years wiped out the cash value unless I poured more premium $ into it.

I know now I could have done much, much better with term life insurance and investing in something else. But, that is all in the rear view mirror now.

Overall I paid $35,653 in premiums over 29 years and withdrew a total of $42,697 at final surrender plus had whatever the value of the insurance coverage for the duration.

This may not be related to the original question but I would look closely at monthly "service charges" and "premium loaders" that are a percentage of gross premium paid. Overall it was costly compared to other instruments for wealth building, to say the least. For a 26 year old ignoramus, it was a start.