It seems like every day there is a new “big idea” for shielding both wealth and income from the long reach of the Internal Revenue Service. Surprisingly, the latest hot take on tax reduction and wealth protection centers on an investment most people consider about as trendy as an over-60 men’s bowling league: it’s called life insurance.
Types of Permanent Life Insurance Policies
Whereas term life insurance offers only a death benefit that diminishes over the years, a permanent life insurance policy offers a guaranteed death benefit and builds cash value over time. In the case of whole life insurance, accumulating cash value comes solely from paid-in premiums. Greater cash value growth can be obtained with universal life insurance policies, which are linked to one or more investment accounts.
Indexed or fixed universal life policies are conservative, with growth dependent either on a specific market index or on an account paying a (low) fixed interest rate. By contrast, the cash value accumulation of variable rate policies derives from market-based investments: Thus, they involve greater risks but potentially far greater growth.
What Is Private Placement Life Insurance?
Private placement life insurance, or PPLI, is a customized version of variable rate insurance not available to the general public. At present, PPLI policies are more often offered by banks, hedge fund managers, and niche insurance companies than by the big names in traditional insurance. For the most part, providers of PPLI have remained tight-lipped about the entire business, with word spreading through seminars and other events restricted to the investing elite.
Who Qualifies for a Private Placement Life Insurance Policy?
Generally, PPLI is offered only to “accredited” or “qualified” investors—those who have substantial investable assets, a documented investment track record, and certain income levels. Pinning down precise definitions of these terms is extremely difficult, however. Consult a qualified insurance professional to determine if your client qualifies.
What Are the Tax Benefits of Universal Life Insurance?
All universal life insurance policies, private or public, offer important tax benefits for the policyholder, including:
- tax-free growth of the cash value of the policy;
- tax-free access to accumulated cash value via loans or withdrawals (note that loans and withdrawals can reduce the death benefit); and
- tax-free passing along of wealth to heirs via the death benefit, provided the policy is established within a life insurance trust separate from the policyholder’s estate.
Note that the tax code restricts the investment options available to a life insurance policy issuer. Any arrangement with a financial services provider that involves freewheeling speculation on the market will be classified by the IRS as an investment account, not an insurance policy: Thus, it will be subject to capital gains and estate taxes.
Why Is Private Placement Insurance More Desirable Than Publicly Sold Policies?
Given that all variable universal life policies, including those offered to the general public, provide essentially the same tax benefits, you may be wondering why people are getting their financial shorts all bunched up over PPLI. Here are just a few of the key advantages of private placement insurance:
1. Institutional Pricing
Because PPLI is sold only to people who are extremely likely to keep their policies up to date and retain them for the long term, providers are able to offer PPLI policyholders significantly lower premiums than the general public would pay for similar coverage.
2. Lower Commissions and Fees
PPLI transactions generally involve substantially lower commissions and fees than those associated with publicly offered policies.
3. Greater Choice in Investment Strategy
Since every policy is customized, individuals investing in PPLI can seek out providers whose investment strategies align well with their own financial goals. Often, the provider will offer the investor the choice of several hedge funds or other investment packages. No publicly available life insurance offers policyholders that kind of control over how the value of the policy will grow.
As appealing as such control may be, however, it is severely restricted once the PPLI policy goes into effect.
The All-important “Hands-Off” Rule and Penalties for Meddling
In my previous article on captive insurance companies, I described the IRS’s reliance on the arm’s-length standard, which essentially states that in any legitimate (that is, nontax-sham) negotiation, a business will act in its own best interest.
With regard to variable life insurance, a key arm’s-length assumption is that the investment goals and strategies of the insurer will never exactly match those of the insured. Therefore, once the insurance agreement is inked, the holder of any universal life policy is strictly forbidden by IRS rules from attempting to influence the investment decisions of the insurance company or its representatives.
IRS enforcement agents have been known to drop the hammer hard on those who breach this critical boundary separating insurance agreements from taxable investment accounts. The message is clear: You can discuss investment strategy with your PPLI provider all you want when setting up the policy and negotiating the agreement, but thereafter, back off.
Conclusion: The Meeting of Estate Planning and Shrewd Investment
When properly set up, a PPLI policy can provide both tax-free wealth growth and solid estate protection for your clients’ heirs. Little wonder that this very old investment idea is suddenly the hottest new thing in tax planning.
This article is not tax, legal, or other professional advice and cannot be relied upon for any purpose without consultation and advice from a retained professional.
Harvey Bezozi is a CPA and CFP. More information can be found at YourFinancialWizard.com.