Insurance - a comparison to IRA accounts. (Individual Retirement Accounts) (Personal Financial Planning)by Adelmann, Richard L.
The 1986 tax reform severely curtailed Individual Retirement Accounts (IRAs). There have been recent discussions in Washington, DC, to improve the tax benefits of IRAs. By the time this article is published, some action may have been taken.
Oddly enough, the tax deduction for $2,000 IRA contributions was never as powerful as the tax deferral on interest, dividends and capital gains inside the IRA. For example, if a taxpayer could have started an IRA at age 28 and contributed $2,000 per year for 37 years, the total contribution of 74,000 would only have generated $37,000 in federal tax savings even at the maximum 50% tax rate in effect in 1985. Over the same 37 years, if the funds could have been invested at 12% (the compound growth rate earned over the last 25 years by average equity mutual funds) the IRA would have grown to $1,363,780. That means an additional $1,289,780 of tax-deferred income between ages 28 and 65. Furthermore, the tax deferral could continue beyond age 65 to 70-1/2! After age 70-1/2 the deferral continues except for the mandatory distributions based on life expectancy.
While taxpayers and planners have verbalized the loss of a few thousand dollars of lifetime deductions, they may have overlooked the opportunity to defer tax on many dollars of interest, dividends and capital gains.
Insurance may provide the overlooked answer. Unlike IRA accounts, insurance has no $2,000 contribution limit and no requirement to withdraw at age 70-1/2.
Comparison Of Life Insurance Products that Shelter Income
Whole life insurance is a level-pay contract which is guaranteed by the entire net worth of the life insurance carrier, and possibly by a reinsurer. The guarantee is that if the owner pays the scheduled premiums, upon the insured's death the carrier will pay the face amount of the policy to the named beneficiary. To counteract the fact that the annual risk of mortality increases with age, the insurance company collects extra premium in the early years of the policy and puts it into a cash value account where it earns interest. The cash value belongs to the policy owner and is always available by loan or upon surrender of the policy.
The cash value account works two ways to keep the premium level: 1) The interest earned on the cash value helps pay the rising cost of the increasing risk; and 2) since the face amount of the death benefit is fixed, the cash value funds part of the benefit, so the insurance company's risk is only the unfunded portion. The policyholder is buying progressively less insurance as it gets more expensive. By age 95 or 100 the cash value account equals the death benefit. The actuaries have it all worked out.
The guarantees in whole life insurance are frequently criticized because they only guarantee that the cash value will earn 4.5 or 5%. The pricing is criticized because insurance company actuaries assume that modern medicine will make no further progress in extending life expectancies beyond what was average in 1980. In spite of screening for medical problems and dangerous hobbies, the actuaries assume their preferred insurers will experience the same mortality as the population at large.
Those criticisms are valid only for the preliminary pricing process. The insurance companies expect to beat every assumption. However, who knows what interest rates the investment people will be able to earn on new premiums received and on earnings reinvested 40 years in the future? Who knows what AIDS and related illnesses will do to life expectancies? If the insurance company achieves lower mortality rates through astute underwriting and achieves higher investment returns than it guaranteed, the difference will be rebated as a dividend in a guaranteed whole life policy from a mutual company or from a participating policy issued by a stock company.
A financial planner who recommends "buy term and invest the difference" should be prepared to show how his alternative plan can beat the life insurance security with the tax deferred investment growth. In the factual world "buy term and invest the difference" can result in "buy term and skip the advantaged investment."
Variable Universal Life insurance
A legitimate criticism of guaranteed insurance is that it missed an opportunity over the last 50 years. Cash values were primarily invested in Treasury bonds and AAA Corporate bonds. Over the last 50 years stocks have outperformed bonds by an average of 3% per year. Investors in whole life insurance have enjoyed lower returns than investors in equities.
To respond to this criticism, life insurance companies developed non- guaranteed products called "variable" life. Annual premiums are established based on expected rather than guaranteed rates of return and the policy owner is given a choice of investment pools (like a family of mutual funds) ranging from money markets, zero-coupons, junk bonds, blue-chip stock, emerging growth companies, and others. The policy owner can select one or several pools and switch from pool to pool. The frequency of switches is restricted by the policy. If the investment results exceed the return projected when setting the annual premium, the premiums can be reduced or the face amount of the policy can be increased. Alternatively, premiums must be increased or benefits reduced if investment results are unsatisfactory.
The word "annuity" used to imply the reverse of life insurance. Whereas life insurance exchanged a lot of little payments for one big payout at death, an annuity contract exchanged a lump sum for a lifetime of guaranteed little payouts. Today the term "immediate annuity" is used for the classic annuity, to distinguish it from the many hybrids. Deferred annuities are hybrids which accumulate and compound principal over a period of time before they are "annuitized" or converted into a guaranteed annuity paying a guaranteed income for life and/or a certain period.
Deferred annuities offer the same guaranteed and non-guaranteed formats as life insurance policies. During the accumulation period there is a small life insurance contract guaranteeing the principal for life regardless of investment results. In a variable annuity the investor is responsible for directing the annuity values into one or more of a variety of investment pools similar to mutual funds (and managed by many of the same managers).
Tax treatment of withdrawals from variable annuities differs from that for variable life insurance. The variable life policyholder can borrow cash values free of tax if modified endowment rules are avoided. Any borrowing from an annuity is treated as a withdrawal and is subject to income tax and a 10% penalty before age 59-1/4.
The choice between variable annuity and variable life depends on the investor's profile. A young investor who has acquired more debts (i.e., mortgage) and responsibilities (i.e., spouse and kids) than assets, will need the variable life insurance because of its high death benefit feature. An older investor who has paid down the mortgage and educated the children can avoid the higher mortality charges and get a higher net return with periodic payout in an annuity.
A planner can counsel the younger investor to convert, by a Sec. 1035 tax free exchange from life insurance to an annuity as the situation changes later in life.
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