Why do people use cash value life insurance?
Cash value life insurance and annuities have been used to provide pension benefits long before 401k's and IRA’s came into existence. These are the only asset classes that can provide lifetime income, no matter how long you live.
Even if they run out of money, they never stop paying income. And income is important because it is used to pay for the things we need or want.
Features of cash value life include:
•Tax Deferred Growth
•Tax Free Income
•A Market Driven Rate of Return
•No Loss of Principal
•Tax Free to Your Heirs
But what do these things actual mean and do for you?
“One benefit of cash value life insurance is that it can provide guaranteed lifetime income.”
The order of withdrawals from different types of accounts can have a significant affect on increasing your net worth. Tax diversification is part of this strategy.
A cash value account with annual reset feature don't go backwards due to market declines, so you don't have make up for prior loses or time. This can result in higher ending value.
Guaranteed Safety Features
By protecting consumers from fluctuations in market value – cash value life are not only much safer than stocks, they are even safer than bonds and bond mutual funds.
Comparing the cost of cash value life with other investments
Cash value life insurance, when properly designed is capable of costing far less than an investment account.
It is true that in the early years of the policy, the cost is higher compared to a typical investment account, however, over the long-term accumulation of an account, cash value life insurance cost much less than other investments.
Why or How? Because the cost of insurance, which is a major cost component of a cash value life policy can be designed to get increasingly smaller as the cash value account builds over time. So as the cash value gets larger, the cost of the policy get smaller.
Comparatively, as investment accounts get bigger, the cost for the investment also get bigger.
This is a basic cost example. If you want to discuss further, click HERE.
What is a tax diversification strategy?
"Tax diversification can give you more to spend."
click to jump to tax diversification
Why is life insurance used to accumulate savings?
For those people that appreciate the value of a safe, stable way to accumulate funds, cash value life insurance, in addition to the death benefit provides it’s owners with;
Safety: Life insurance companies are reserved based entities meaning they must account (have a reserved amount) for every dollar they take in.
Earnings in addition to guaranteed rates: Cash value life policies may provide non-guaranteed earning from dividends or market linked performance in addition to minimum guarantees.
Asset protection: Life insurance and annuities may receive state protections from lawsuit, bankruptcy and creditors. Protections vary by state, however, a few states, such as Florida, have strong asset protection for life insurance and annuities.
Professional money management: Life insurance companies professionally manage immense sums of money to generate the highest rate of return with the maximum amount of safety.
Investing billions of dollars in cash value life insurance
Perhaps that is why all the major banks and most regional banks invest so heavy into cash value life. According to federal reserve filings, major banks in the U.S have placed billions of dollars into cash value life policies. By some estimates, these banks have invested more of their Tier 1 capital reserves, which is a banks most important asset and a key measure of its strength, into permanent life insurance underwritten by major life insurance companies.
Managing investments is time consuming and it's difficult to get things right all the time. People that want to avoid the following investment pitfalls may want to consider cash value life insurance for a portion of their money.
Market risk is a results of many different types of risk. Risk such as interest rate risk, political risk, tax risk, geographical risk, systematic and unsystematic risk all need to be considered.
Market timing – no one can predict tomorrow, whether it’s tomorrow’s lottery numbers or the best time to get in and out of the market.
Business owners choosing cash value life insurance
As a business owner or executive, do you play with risk-reward in how you work, or do you apply stable, enduring business practices?
I think most business owners, professionals and executives would avoid risky situations in their own professional dealings.
Considering the risk involved, why would you do something different with the fruits of your labor?
The same steady, hard working progress you made with the investment in yourself can also be made with the money that you’ve earned.
Cash value for saving, has numerous investment features
To be sure, cash value life insurance is an investment. It does many of the same things that other investments do, plus it does things that no other investment can accomplish. And it does these things without the risk of losing principal to market loses. However, in this way, cash value policies are similar to savings account. Savings account earn interest. Once interest is earned it can not be taken away.
Annual Reset Feature of Cash Value Life
In some aspects, cash value life insurance function in a manner similar to savings accounts. Once the account earns interest, it cannot be taken away because of negative market performing years. This is because cash value life policies typically have an annual reset feature that locks in gains.
Annual reset helps these accounts capture more upside and limit negative market downturns from affecting cash values.
What happens when loses are taken out of the equation?
The short answer is that having no down year’s changes risk, allowing an account can grow more. It earns more interest.
To illustrate, take a look at the average returns for the market, represented by major market index of large company stocks for 80 plus years, from 1930-2014. You can also look at any other long term period and compare the results.
The average return excluding dividends and re-investments was about 6.33%. This time period represents positive and negative years.
However, if loss years are removed from the same time period, the average return increase to 11.67%.
A cash value life insurance policy that applies a spread, cap or participation rate may reduce that return from 11.76% to 8.1%.
For some people, especially long-term savers and investors, it may well be worth earning less to avoid negative years.
Remember, cash value policies typically use market index linked values to credit interest to the cash value account. The accounts participate in the market but they are not directly invested in the market. This enables cash value life insurance to capture only upside gains while avoiding loses.
In return for eliminating loses from the interest crediting calculation, these accounts typically use some type of interest limiting feature. These are normally called caps, spreads and/or participation rates. You can read more about these here.
The affect of these interest credit limiting features is that it can reduce and in some cases, can even eliminate interest credits for any given year. The benefit is that negative market performance, which can take away prior earnings and set you back are not counted against these accounts.
Using both taxable and tax-free accounts to accumulate and distribute income is a form of tax diversification.
Taxes is a constantly changing filed and so who knows what the future has in store for taxes. They seem to go up, then down then back again. People have all kinds of theories and speculations about taxes. Economist illustrate that taxes are related to government revenues. The Laffer curve is one such economic theory on the connection between tax rate and government spending or revenues that is rooted back to the 14th century.
The importance of planning into the future
Tax diversified strategies are nothing new. Strategist promote and employ sophisticated tax planning solutions all the time. This is an area in finance where you should seek the advice of a licensed professional in your area.
For illustrative purposes, the diagram below illustrates how having a portion of tax-free income provides greater amounts of money to spend in retirement.
Cash value life protects retirement dreams
“The contribution story of cash value life insurance.”
What happens to a savings or retirement plan if:
An investor contributes $50,000 a year for 7 years into an investment account, then dies. Is that enough to provide for his family? Even if he made a great rate of return on his contributions, it’s likely that the family of someone who can make regular contributions of $50,000 a year will not be oaky for long.
Worst yet, what if the same person got sick enough to lose his income. Normally, when a person suffers a disabling illness or injury, the cost to a family increase due to increase medical expenses, in addition to the loss of that person’s income.
In this way, some situations can be worse than death.
One possible solution to these problems is cash value life insurance. Besides being designed to accumulate cash value, these policy’s can provide a death benefit and cash for critical and chronic illness.
How does guaranteed lifetime income from a cash value policy compare to the possibility of running out of money?
Some people may have the time and expertise to manage withdrawals from their accounts. And they may be unlike most people, according to research that make investment mistakes as the get older. These people may be familiar with and practice according to the 4% rule.
What is the 4% rule and the related sequence of returns risk?
“Sequence of returns risk can be an unexpected event that can quickly deplete a portfolio in retirement.”
The four percent rule is a term developed by the financial planning industry which states the percentage amount a person can withdraw from their accounts through retirement. It also comes with the risk of depleting your money before the need is gone, that is before you die.
As you can image, a theory like this can have devasting affects on a persons livelihood. In general, rules of thumb, I believe are good to explain a concept but can be dangerous if taken literally.
For instance, since the four percent rule was first published it has since been reduced to about 1%. According to the new rule, in order to lessen your chances of running out of income, instead of withdrawing 4%, you should look at withdrawing a bit over 1% from your accounts. Essentially, you need to live on less for your money to last until it’s no longer needed.
Making matters more complicated is the timing of the income start date. There is a greater risk of depleting your account based on the day you start to take income form your accounts. This is called sequence of returns risk.
Retirement Income of $300,000
Without Tax Diversification
Tax Diversified Strategy
Cash Value Life Insurance
$300,000 taxed at 32%1
$150,000 taxed at 22%1
Tax free $150,000 taxed at 0%2
Without Tax Diversification
$204,000 to spend after taxes
Tax Diversified Strategy
$267,000 to spend after taxes
Hypothetical example for illustrative purposes only
1Assumed marginal federal income tax bracket under current rates for married filing jointly.
2If structured properly. Policy loans and partial policy value surrenders will reduce the death benefit of the policy and may cause the life insurance policy to lapse. Distributions exceeding cost basis will result in taxation.
3The cash value in a life insurance policy is accessed through policy loans, which accrue interest at the current rate, and cash withdraws and loans will decrease the total death benefit and total cash value. Policy values are based on non-guaranteed factors, such as dividends and interest rates, which are subject to change. Therefore, the supplemental income is not guaranteed.
These are some ways that cash value life can be;
Part of the Solution
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