College Planning Using Cash Value Life Insurance

Transcription

1 College Planning Using Cas Value Life Insurance CAUTION: Te advisor is urged to be extremely cautious of anoter college funding veicle wic provides a guaranteed return of premium immediately if funded in a lump sum. Tis type of policy is a modified endowment policy and carries a 2-3% return wic takes several years to begin accumulation due to payment of commission in te early years. Some advisors recommend selling assets to take tem off te aid formulas and put tem in tis type of MEC policy. It is a big error to assume tat tis will cause te EFC to drop enoug so tat a college will ten give more aid. In fact, by liquidating assets, te client may incur tax liabilities; tey may incur an opportunity cost by liquidating ig return investments and putting tem into a very low returning investment; tey may create new costs suc as mortgage interest due to a refinance, and so fort. In te end, te college may grant little or no additional aid due to iding assets. Advisors ave been sued for creating new costs and lost opportunity for clients in te opes of getting more aid wic never was realized. Tere sould always be good economic rational wen moving money around suc as to better diversify a family s total financial life plan. To te extent tat te EFC can be lowered and results are beneficial, ten te advisor sould not be concerned wen coosing between two sound strategies. Remember, te merit of te student and te coice of scool are te most important factors in receiving more aid. Industry speak If you listen to many of te insurance companies and independent marketing organizations (IMOs), you ll be of te opinion tat funding a cas value life insurance policy (Equity Indexed Universal Life (EIUL) Insurance), is a no-lose proposition. Wen you fully understand te numbers, you ll know tat suc statements are inaccurate and misleading wic is wy an education module covering tis subject matter is important to read (so you can give client-first advice). A quick review College Funding using 529 Plans Paying for a cild or a grandcild s college education as become increasingly difficult as te costs of college continue to increase. It really is unbelievable ow muc college costs today (and it increases every year). Copyrigt Page 1

2 Today, 529 plans seem to be te tool of coice to pre-fund and build a taxfavorable pool of money for college education. See te following Pros and Cons to 529 Plans: Pros 1) Once funded (after-tax), te money can grow tax-free and be removed taxfree for qualifying college education expenses. 2) If owned by te parent or grandparent, once funded correctly, te assets (including growt) are out of teir estate for estate tax purposes. 3) If owned by te parent or grandparent, if te cild or grandcild does not go to college, te money can be used by te person funding te 529 Plan and would act like an IRA (wit similar income taxes and penalties). Cons 1) If te cild does not go to college, te growt on te money is taxable and subject to potential penalties wen witdrawn/used by te parent/grandparent. 2) Te money in a 529 Plan is subject to loss due to market risk. 3) 529 Plans are not self-completing sould a parent or grandparent die prior to complete funding. 4) 529 Plans ave funding limits. Funding is limited by te $13,000 annual gift tax exclusion (altoug tey can be super-funded in year one by pouring in all of te first five year s wort of gifts all at once, $65,000). Using Cas Value Life Insurance as an alternative funding veicle for college expenses Wy would anyone use cas value life insurance as a funding veicle to pay for college education? Good question; and ere are te simple and easy to understand reasons. (Initially, it will be assumed tat te life insurance policy will be purcased on a cild s parent.) 1) Life insurance is a self-completing plan. Let s assume Dad is te breadwinner in te family; and if e appens to die wen a cild is young witout fully funding a 529 plan, tere will be a significant sortfall wen te cild goes to college. Wit life insurance, if Dad dies, a sizable income tax-free deat benefit will pay to te eirs wo can coose to use tat money for college education. Copyrigt Page 2

3 2) Money in a cas value policy will not only grow tax-free but it can be removed tax-free wen used to pay for college expenses (policy loans). 3) If te cild does NOT go to college, te policy will be a terrific tax-favorable, wealt- building/retirement tool for te parent. If you ve read te education module on cas value life insurance, you ll know wy cas value life insurance can be suc a powerful wealt building tool. 4) After borrowing from te policy, it will still ave cas in it and sould grow for years to come. Tat means tat money can be removed tax-free later on wen te parent is in retirement (tis is not possible wit a 529 Plan). 5) Money in a cas value life insurance policy is not a countable asset wen a cild goes to apply for financial aid for college (tis is te case wit most colleges but not all). Based on te above positives of using cas value life insurance policies, you d tink it is an easy decision to counsel a client to use a policy to fund for college education. Unfortunately, tat is not te case. As you will see wit te following numbers, cas value life insurance as a college-funding veicle only works wen a client not only funds te policy for future college expenses but also overfunds te policy wit cas to be used as a supplemental retirement veicle for te parents. Te following examples will clearly illustrate te problems wit using cas value life insurance as a college funding veicle wen it is not properly overfunded, and some examples will illustrate ow cas value life insurance works very well as a funding veicle. Example 1 Assume your client is a 30-year-old (male) parent wo as a 6-year old cild. Assume te cild will go to college at te age of 19 and will be tere for five years. Assume Dad as $3,500 eac year to pay towards a college funding veicle and tat e coose to fund tat money eac year into an EIUL policy every year from te cild s age Assume te policy runs at te MEC minimum deat benefit and tat te annual rate of return is 7.5%. Initially assume tat, wen Dad takes out tax-free policy loans from te policy, e does so wit was loans. How muc could Dad remove from is life insurance policy from te cild s age 19-23? $12,330. How muc could be removed eac year from a 529 Plan were we assume a 1.2% mutual fund expense on te money in te 529 plan? $16,125. Copyrigt Page 3

4 Wic one worked better? Hands down; it s te 529 plan. Wat about using variable loans in te life policy? If you read te life insurance education module, you ll know tat a client can usually take significantly more cas out of te policy wen you assume a variable loan rate (te life illustration is usually setup to ave a lending rate of 1-3% lower tan te crediting rate). In te previous example, wat if te policy ad a 1% positive loan spread? How muc could be removed from te life policy eac year for college? $12,696. Wat if te policy as a 2% positive loan spread? $12, 974. To many wo are used to illustrating variable loans in EIUL policies, te previous numbers won t make muc sense. Wen you run a life insurance illustration at te MEC minimum deat benefit, you almost always are able to take out sizable amounts of cas and significantly more wen you illustrate a 1-3% loan spread. Wy in te previous example did te borrowing figures not significantly increase wit a variable loan? Te answer is quite simple; wile te illustration was run wit te MEC minimum deat benefit, it was not really overfunded. Paying a $3,500 premium may sound like decent amount of money wen funding a 529 plan for college funding, but tat amount is not considered overfunding wen trying to design a life insurance policy to work as a significant cas accumulator. Tere are some very positive tings wen funding a life policy for college funding. Using te current assumptions, te life insurance policy would slowly grow cas back in te policy after te amount assumed ad been borrowed over te five-year college period and would ave $64,000 of cas in it wen Dad turns 70 wit was loans, $142,000 wit a 1% loan spread and $209,000 if tere is a 2% loan spread like te insurance companies believe will appen. Additionally, te deat benefit at age 70 would be $280,000. A client would neiter ave te ability to accumulate more cas to be used tax-free in retirement nor would e/se ave an additional deat benefit for te eirs sould a 529 Plan be funded instead. Wile te above positive sounds great, wen you tell a client tat tey can fund $3,500 into a 529 Plan and remove $16,125 vs. less tan $13,000 wit a life insurance policy if bot ad a gross return of 7.5%, te client is going to usually opt for a 529 Plan. Copyrigt Page 4

5 Fixed Lending EIUL Policies I also ran te numbers using my favorite Retirement Life EIUL policy tat as a maximum lending rate of 5.3% (in oter words it s not a variable loan rate). Unfortunately, te numbers did not improve muc. Te parent could borrow out $14,000 a year for te same time period). Oter mitigating factors Many clients wo ad money in 529 Plans in really regretted te decision due to te fact tat most 529 Plan account balances fell 40% or more over tat 12-mont period. Tis is a significant downside to funding 529 plans and one uge benefit to funding a non-variable cas value life insurance policy (principal protection). Example 2 For example 2, assume tat, instead of insuring te life of te parent, te 6-year old s life is insured instead. Te same amount could be taken out of te 529 plan from te cild s age as funded at $3,500 a year: $16,125. How muc could be removed from te life insurance policy tax-free from ages on te policy insuring te 6-year old cild s life? $15,339. As expected, te numbers are more tan wat could be removed from a life insurance policy on te Dad, but te numbers still fall a little sort of wat could be removed after-tax from a 529 Plan. It is also important to understand tat te examples are all run to maximize cas value wic also minimizes commissions. Te target premium on Example 2 is less tan $1,000 (mainly because an increasing deat benefit was used). It is also important to understand tat te illustration in tis example and te oters in tis module are run using te maximum witdrawal amount from te life insurance policy wen illustrating ow muc can be borrowed. In tis example, tere is only $1,097 in cas left in te policy at te end of te fift borrowing year. Tis is NOT a conservative example. If te policy does not perform as illustrated or better in te next year and subsequent years, tere will be a call for premium; or te policy will lapse. Keep in mind tat tis policy must stay in force for te rest of te cild s life in order for te loans to not be taxable. Tat s a long time and one of te pitfalls of using cas value life insurance as a funding veicle on te life of te cild. If you want to use conservative illustrations, you sould run tem were tere is a target amount of cas left in te policies at te end of te borrowing pase. It is Copyrigt Page 5

6 recommended tat you leave 23% of te premiums paid as a cas value at te end of te borrowing pase. If you requested from te life insurance software tat te policy ave $14,000 in cas surrender value wen te cild turns 23 in tis example, te cild would be able to borrow out: $12,532 at age 19 $12,908 at age 20 $13,296 at age 21 $13,694 at age 22 $14,105 at age 23 Total: $53,239 How muc could be removed from te life insurance policy using max level income? $15,339 x 5 = $76,695. How muc could be removed from te 529 Plan (wic also assumes a level income and tat te stock market doesn t go in te tank sortly before or sortly after te cild goes to college)? $16,125 x 5 = $80,625. Te point wit te previous exercise as well as wit all of tese illustrations is to point out to advisors tat funding life insurance for college planning sounds easy. Just fund a life policy for X amount of years and sow max borrowing. If you ave te rigt variables manipulated te rigt way, you can make life insurance look like a very attractive option for college funding; owever, te trut of te matter is tat coosing to use life insurance as a college-funding veicle is a very complex matter wit many variables tat must be discussed wit and disclosed to clients so tey can make an informed decision about ow to best fund for teir cild s college expenses. Example 3 (one tat gets closer to making life insurance work better) Now assume tat instead of funding $3,500 every year from te cild s age 6-18, fund $9,100 eac year for five years (te same total funding amount as te earlier examples and assuming it s on te Dad s life). Assume te same 7.5% rate of return. Note: Tis illustration was run on te parent, not te 6-year old cild. Wen sort funding on te cild, te amount borrowed did not reac te level of wat could be removed via borrowing from te 30-year old parent s policy (it was close but not quite as muc). How muc could be removed from a 529 plan from ages 19-23? $20,163. How muc could be removed tax-free from te cas value life policy? $17,269. Copyrigt Page 6

7 Wat if tere is a 1% loan spread wit te policy loans? $19,175. Wat if tere is a 2% loan spread wit te policy loans? $19,562 (getting closer). Is tere a minimum funding example using a reasonable rate of return were cas value life works better tan a 529 plan? Yes, make te cild younger or te parent younger. Example 4 Now assume te cild is just being born (zero for calculation purposes). How does tat elp te numbers? Quite a bit because te life insurance policy as more time to accumulate cas and overcome initial up-front loads. Note: Tis illustration was run on te parent, not te 1-year old cild. Tis time te amount tat could be borrowed from te cild s policy was significantly lower tan from te parent s policy. How muc could be removed tax-free from a 529 Plan using te same assumptions from Example 3)? $29,051 eac year from te cild s ages How muc could be removed tax-free from te life policy? $32,075 from te life policy if tere is a 2% spread on te loan. $31,438 from te life policy if tere is a 1% spread on te loan. $30,784 from te life policy wit was loans of 7.5%. Wit te rigt fact pattern, minimum funding of a life insurance policy can work as a better wealt accumulation tool for college funding. However, as you can see, te fact pattern is very narrow toug. Additionally, wat appens if over time te stock market and te S&P 500 only average say 3.5%? How muc could be removed from a 529 plan? $13,030. How muc could be removed from te life insurance policy? ZERO. Tis is a little misleading since tere is still a cas surrender value in te policy of approximately $49,000 and te guaranteed cas value amount equals approximately $32,000. Te illustration software simply does not allow borrowing from te policy due to insufficient cas. Te account value in te 529 plan is $60,000. Copyrigt Page 7

8 If you are going to pitc using cas value life insurance to your clients as a college-funding veicle, you better be giving tem full disclosure wic would include information about wat appens wen returns over time are low (not wat were reasonably illustrated at inception). Overfunding a cas value life insurance policy for college planning (it works!) Te definition for tis education module of overfunding is NOT just funding a policy at te MEC minimum deat benefit but instead is defined as paying a sizable premium into te policy over a sort period of time (10 or less years). Wat s sizable? In te college funding scenario, it s funding te policy wit not only te amount of money a client can budget for college planning but also for supplemental retirement planning/income for te parent(s). Were can a parent find tis oter/extra money to fund into te life policy to overfund it? Two main places for non-affluent clients (affluent clients simply ave te money and need to coose to allocate it to te policy wereas non-affluent clients ave to find te money) 1) Reallocate money from a 401(k) plan Many clients fund tax-deferred 401(k) plans for retirement savings. Wile tis sounds like a good idea for most clients under te age of 50, funding cas value life insurance after-tax will be a better, more tax favorable, and conservative way to grow wealt (see te education model on qualified retirement plans for te numbers to back up tis assertion). Terefore, instead of funding $5,000-$15,000 into a tax-deferred qualified plan, te client can allocate tat money to funding a cas value life insurance policy. Tis additional funding will make te life insurance policy work as a muc better cas accumulating tool and sould allow for plenty of money to be used for college funding and as a supplemental retirement plan. 2) Borrow money from a ome Many clients ave as teir only major asset te equity in teir personal residence. Many times clients strip equity from teir ome at te time teir cildren go to college because tey neglected to properly plan. Tis can also be done wen cildren are young and wen using tat money to overfund a cas value life insurance policy, it will significantly increase te financial viability of using te policy bot as a collegefunding veicle and a tax-favorable retirement veicle. Copyrigt Page 8

9 Example 5 For tis example, assume tat te client is 40-years old instead of 30. Assume e as two cildren ages 13 and 10. Assume te client as not funded for is cildren s education and as sufficient income from all sources to overfund $50,000 a year into an EIUL policy every year (6) until te first cild goes to college. Te client is funding te policy not only to fund for college education but also to fund for is own retirement. How did cas value work to elp build wealt for college and to provide a tax-free retirement income stream for te parent? It worked really well. Using a conservative 7% rate of return, te parent can remove $20,000 a year tax-free from te life policy wen is first cild starts college at age 19 and can remove $20,000 a year for tat first cild s first tree years of scool. Ten te parent could remove $40,000 tax-free for two years wile is second cild starts scool and wile te first cild finises up years 4-5 and ten $20,000 a year eac year for tree years wile te second cild finises up years 3-5. $20,000 Years 1-3 $40,000 Years 4-5 $20,000 Years 6-7 It certainly makes sense tat te client can pull out $200,000 to be used for is cildren s education since e paid premiums of $250,000. Te question is: How muc can te client borrow from te policy in retirement from ages 66-85? $66,108 tax-free every year for 20 years wit was loans $91,127 tax-free every year for 20 years wit a 1% variable loan spread $180,715 tax-free every year for 20 years wit a 2% variable loan spread Tis is te POWER of using cas value life insurance to fund for college planning AND retirement. Summary on using life insurance for college funding. Using cas value life insurance from a pure financial standpoint is very difficult to justify for most average clients looking to minimum fund te policy wen teir goal is to only fund for college planning (unless you weig te additional advantages cas value life as over using 529 plans). Advantages suc as: Copyrigt Page 9

10 -te life policy self-completes a plan for a parent wo dies. -locking in investment gains every year. -allowing te client to use te funds tax-free for any oter purpose. -allowing te client to keep te policy in-force until e/se retires and potentially borrows more money out of te policy tax-free. -te fact tat cas value life insurance is not a countable asset for financial aid calculations. -also, Retirement Life can come wit a long-term care rider to protect te client wen in retirement. However, wen a client properly overfunds a cas value life insurance policy not only for college funding, but also for supplemental retirement planning, it is very powerful and as a ig probability of financial success in addition to te oter advantages listed above. Caution and full disclosure are te keys to giving your client proper advice wen it comes to using cas value life insurance to fund for college planning. Tis is a very powerful and useful topic and advisors wo coose to use it to elp teir clients will significantly grow teir business wile elping clients and teir cildren in te process. Special attention needs to be made wen running illustrations. Depending on te age of te client, age of is/er cildren, ealt of te client, and te amount and time frame for funding a policy, it will make more sense to fund a policy on eiter te cild or te parent. Advisors must understand all te nuances to properly illustrating conservative real-world scenarios for clients so informed decisions can be made. Copyrigt Page 10