In Episode 35, I'm discussing the advantages and disadvantages of using permanent life insurance as a source of liquidity to purchase a real estate property, fund renovation expenses, or create retirement income.
“The first thing I want to emphasize is that a policy loan is not income.” - Cynthia Meyer
This week on Real Life Planning Podcast:
“One of the biggest disadvantages for using life insurance as a cash flow funding strategy is that there are a lot of fees.” - Cynthia Meyer
“I want you to consider the life insurance question solely in the context of your estate plan. Again, there are other ways to create future sources of liquidity for yourself without tying yourself up into a long-term life insurance contract that you might not need and that's expensive.” - Cynthia Meyer
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Host Cynthia Meyer welcomes fascinating guests to share real life stories of how they are realizing their financial potential. Each episode explores practical, realistic steps to create results.
TRANSCRIPT for Episode 35
[00:00:11] What are ways that real estate investors can use life insurance to provide sources of liquidity, either for a real estate purchase or renovation, or perhaps to create retirement cash flow later on? So, if you listen to the radio these days, you're really likely to hear a lot of commercials promising tax free retirement income with no stock market risk.
[00:00:38] If this sounds a little bit too good to be true, something to pay attention to that feeling, right? So if you call a toll free number or you sign up on a website, you will probably get a follow-up contact from a life insurance agent who wants to show you how you can use whole life insurance or universal life insurance for tax-free retirement income.
[00:00:58] I don't know what you think, but to me it sounds a little bit too good to be true, right? Can permanent life insurance really be a retirement plan or a source of being able to create your own bank, if you will? So I want to invite you to be very, cautious here.
[00:01:20] Life insurance is not designed for either of these two purposes. It's not designed for retirement savings. It's not designed to create your own financial institution. Permanent life insurance is primarily designed to protect people in your family who rely on your income to maintain their standard of living.
[00:01:42] So the permanent aspect of permanent life insurance means that this insurance protection stays with you for your life, for your entire life, as long as you're paying the premiums. So both types of permanent insurance, whether it's whole life or universal life, for example, include both a death benefit component and a savings component.
[00:02:04] The difference between permanent insurance and term insurance is term insurance does not include a savings component, just the death benefit component. The savings component in a permanent insurance policy consists of policy cash value, which is the amount of accumulated policy value from that savings.
[00:02:23] Basically, you're paying extra in every premium in order to accumulate savings in the policy. That would be paid out if the policy were surrendered early. That cash value or surrender value would be paid out to the insured person if they surrendered the policy early, as opposed to passed away.
[00:02:41] This life insurance as a retirement plan, I realize I'm using air quotes a lot here, so life insurance as a retirement plan or life insurance as a financing plan for real estate cash flows are based on the insured person borrowing against the accumulated cash value- the accumulated savings component of that policy.
[00:03:04] It is correct that you may borrow against cash value of a life insurance policy in some circumstances without taxes, and that invested premiums do grow tax deferred. There are some significant disadvantages for following this strategy, and so I want to talk to you a little bit about them so you understand what they are. What the possible benefits and challenges are and you go into this kind of a discussion with the insurance agent completely wide-eyed.
[00:03:33] So, the first thing I want to emphasize is that a policy loan is not income. A policy loan uses the cash value of the policy as collateral, and the insurance company charges the borrower interest on the loan. The interest goes to the insurance company, not back to you. So there are a lot of names for this particular strategy and they're a little bit misleading because the insurance company is making the interest on the loan, not the policy holder. So that interest rate may be the same, it may be higher or lower than the rate you are credited as a policy holder on the growth of the policy cash value; that depends on the particular policy.
[00:04:21] So, Michael Kitces, who is one of the co-founders of the XY Planning Network, that's my financial planning network, he called this in a research article, that this borrowing strategy is nothing more than a personal loan from the life insurance company. That is not income, right? So all those folks that are saying, oh, this is a retirement income strategy...not income. Okay? It's a loan. You have to pay it back.
[00:04:47] The second is that policy dividends from certain types of policies certainly can be helpful, but they're not guaranteed. And so consequently relying on policy dividends to help in the growth of the cash value may not be an accurate assumption.
[00:05:06] So certain types of insurance companies do pay dividends to policy holders who hold what's called a participating policy; when their annual results are good- meaning when the company's results are good. And those dividends can be applied towards future premium payments or use to purchase additional coverage. The insurance company is not necessarily going to make a profit every year so dividends may not be reliable. So checking out the financial health record and rating of the insurance company is certainly important If this is a strategy that you are considering because you may or may not receive dividends.
[00:05:40] The other thing it's important to know is that there could be potential tax problems with a strategy where you're building up a large cash value and then you're borrowing large sums against that cash value. And so let's talk about this a little bit.
[00:05:59] So dividends from participating policy, as we talked about which may or may not be guaranteed, they're not taxable.
[00:06:05] However, strategies that recommend borrowing against the cash value have potential tax problems. So again, those two main strategies are one, borrowing against the cash value on a temporary basis to make an offer on a property. Somebody who wants to be in a good position make a cash offer, they have a large cash value in their policy, so they borrow against it for a short period of time. Once they've completed the deal, then they refinance it with a regular mortgage the normal way and pay back the policy loan.
[00:06:36] The other way is this idea of life insurance's retirement cash flow, retirement income where the policy holder basically accumulates a large cash value over time and then just keeps taking policy loans that they never pay back.
[00:06:53] Should you borrow enough of your cash value and you don't pay it back, and that bill for the premiums keeps hitting every year, there is a situation where the policy value could go down to zero. If that happens, if the cash value goes down to zero in these types of policies, the policy holder either has to put cash back in or they risk the lapse of the policy.
[00:07:17] If the policy lapse, then the total amount of outstanding loans against that cash value would be included in your taxable income in the year in which the policy lapse. It's a fairly risky strategy, in my opinion.
[00:07:29] So the other thing I want you to know is there's really no free lunch. One of the biggest disadvantages for using life insurance as a cash flow funding strategy is that there are a lot of fees. You are paying for the insurance component first of all! If you die early, your beneficiaries would receive the full death benefit. So you'd be charged underwriting costs and mortality charges, et cetera, to maintain the life insurance policy throughout your whole life, you're going to be charged these charges and you may actually not need the insurance protection for your whole life. Plus you're paying for the distribution of the policy. That's a nice way of saying that the insurance salesperson is getting a commission for selling it to you. So somebody's getting paid and those fees and charges eat into the type of returns you might otherwise receive with that money if you were to invest that money independently. You open a low cost brokerage accounts- Vanguard, for example, and you invest that money into buying and holding tax efficient index funds.
[00:08:33] So, let's take a look at this and see what are some possible alternatives to using whole life or universal life insurance in conjunction with policy loans, to create future cash flow for yourself.
[00:08:49] So one option which I like a lot and may fit for people who don't have a permanent life insurance need is to create over time, is to fund a taxable brokerage account with well diversified, low fee, tax efficient investing. These are generally index, ETFs- exchange traded funds, maybe even mutual funds and to build that low cost, low turnover, tax efficient portfolio over time as you can.
[00:09:21] And then couple that with a term life policy or a ladder of term life policies that meet your family's actual life insurance need. If you don't think you need permanent insurance, if you only need insurance until your kids are in their twenties and well established and their college is paid for or you have enough retirement savings that you don't need to leave an estate should you predecease your spouse, for example. Those are all questions you can figure out with your financial planner and your tax advisor. The combo of those two things can help you accomplish much the same strategy with a lot less hassle and more flexibility.
[00:09:59] Many brokerage firms offer securities based lending against taxable brokerage accounts that are pledged for collateral. Often those are interest only loans for some period of time, and then they convert to a regular amortized loan if they don't get paid back eventually. And similar to borrowing on margin, you're pledging your securities account as collateral for some type of line of credit or term loan and that can be with a well diversified, large portfolio, that can be an excellent way of creating liquidity without having to sell securities in a tax efficient way. Coupled with term insurance that lasts for the actual term that you need coverage for can be a very helpful way of protecting your family, as well.
[00:10:48] So again, it depends. Do you need permanent insurance or not? Do you have the capacity to build the taxable brokerage account, which generally you should be able to build a little bit faster than building cash value and a life insurance policy. And then of course, what are the risks and potential rewards of borrowing against securities? That's not a risk-free transaction either.
[00:11:07] So talking through all those things with your financial planner and figuring out if that's a strategy that interests you, which is going to be the best thing for you in your particular situation.
[00:11:17] The bottom line really is, do you need permanent life insurance? I want you to consider the life insurance question solely in the context of your estate plan. Again, there are other ways to create future sources of liquidity for yourself without tying yourself up into a long-term life insurance contract that you might not need, and that's expensive. Think about how much insurance do you need and do you need a permanent policy? If you're a higher net worth investor and you expect that your estate is going to exceed the limit for passing to the next generation without estate taxes, then you may need permanent insurance.
[00:11:55] You may need permanent insurance if you have a special needs child, or you have a stay at home spouse or a, closely held business, for example. So, those are all important questions to consider, but make the insurance decision based on whether or not you need the insurance, not whether or not you need a policy loan in the future.
[00:12:12] There are alternatives. I want to make sure you know the risks as well as the potential rewards. It's being discussed a lot in the real estate space. And so take your time, do your research, run it past your financial planner, and, hopefully you'll make the choice that's best for you.
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