Cash Value Insurance: An Overlooked Investment with Big Tax Savings

This blog is part of a series by Dan Solin, author of The Smartest Money Book You’ll Ever Read. The book incorporates many useful money management tips from Mint.com, and can be purchased via the following retailers :  Amazon, Barnes & Noble, Nook and  iBooks.

In my last blog, I discussed a tax trap for unwary investors who hold shares of mutual funds. Around this time of year, they will be receiving unwelcome notification of a tax liability caused by the trading in their mutual funds, even if they didn’t sell any shares during the year. The tax hit can be especially significant for investors in actively managed funds (where the fund manager attempts to beat the returns of a designated benchmark), because of the higher turnover of those funds.

There is an alternative investment that has significant tax and related benefits, but relatively few investors consider it because of its complexity and much maligned reputation: cash value insurance.

The complexity of cash value insurance favors insurance salespeople, who tend to sell the policies that pay them the highest commission. This practice contributes to its poor standing with investors.

The two main types of cash value insurance are whole life and universal life. I discuss the differences between them in my latest book, The Smartest Money Book You’ll Ever Read. The  initial premiums for both are higher than for term insurance with a similar death benefit, which is the primary reason why most investors fall prey to one of the most harmful mantras in the financial planning world: Buy term and invest the difference.

Buying Term Can Be a Financial Mistake

When it comes to insurance, there is no guide that is right for everyone. According to one expert, if you have a risk tolerance that permits you to invest in riskier assets than conservative bonds, and you will “invest the difference” over a long time period (up to 30 years) when you will no longer need insurance, buying term and investing the difference probably makes sense for you. Most people who fall into this category will be age 45 or younger.

Term insurance also has the benefit of permitting you to afford more protection at a time when you need it the most, simplicity, ease of price comparison between policies and often the flexibility to convert the policy into a comparable cash value policy from the same insurer.

As I noted, the big selling point with term insurance is its price, which is initially lower than cash value insurance. However, as one insurance company observed, purchasing a cash value policy at a young age will likely cost less than buying a 20-year term and trying to renew it in later years because of the significant premium increases in term insurance at the end of the policy term.

Another significant problem with term insurance is that you are not building any cash value. According to Glenn S. Daily, a fee-only insurance consultant, cash value is critical when you need or want to drop the policy because you can do a 1035 tax-free exchange from a life insurance policy to an annuity and defer paying income tax on the gain. If you have a term policy, you have no cash value and it will be very difficult for you to capture the tax shelter benefits of a tax-free exchange.

Of course, there is an obvious benefit to building up cash value. Owning cash value insurance encourages forced savings because there is a strong incentive to keep your death benefit in place. As your cash value grows, you can borrow against it, although loans taken will be deducted from the death benefit paid.

The reality is that many people buy term and spend the difference. As a practical matter, I have never met anyone who had built up significant cash value in a whole life policy and lamented the fact that she could have maximized her returns by investing in the stock market.

The reality is, most investors would end up with more money if they purchased the right kind of cash value insurance. “Right kind” is critical because there are many inferior cash value policies on the market. You should seriously consider retaining a fee-only insurance adviser, with no financial stake in your purchase decision, to be sure the policy you buy is the best one available to you. You can find a list of fee-only insurance consultants here.

The Tax and Related Benefits of Cash Value Insurance

If you decide that cash value insurance is appropriate for you, you are poised to reap some significant tax and related benefits. You can find a good summary of those benefits here. They include:

Tax Deferral

The accumulation of the cash value in your policy is not subject to current taxation.

Tax Free Loans

You can borrow from the cash value of your policy without incurring income tax liability. These loans are considered debts by the IRS. They are not taxable distributions. There are exceptions to this rule, so be sure you understand the applicable limitations on borrowing.

Tax Free Distribution at Death

When you die, your beneficiaries receive the death benefit of the policy without incurring any income tax. This is true for both term and cash value policies.

Exclusion from Estate Tax

It is possible to structure your insurance so that policy proceeds are excluded from estate taxes. This requires careful attention to beneficiary designations and policy ownership. You will need the advice of your tax and legal advisors to be sure it is done in compliance with current law.

Investment Flexibility

Finally, there is another, little-known benefit to cash value insurance. According to fee-only insurance adviser Scott Witt, an insurance expert can assemble a portfolio of cash value policies that will rival a portfolio of fixed-income investments. “If properly structured, it may never go down,” Witt notes, “and it can allow you to be far more aggressive in the balance of your portfolio.”

Savvy investors would be wise to ignore simplistic rejections of cash value insurance and consider adding it to their investment portfolio.

Dan Solin is a Senior Vice-President of Index Funds Advisors (ifa.com).  He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read, The Smartest Retirement Book You’ll Ever Read and The Smartest Portfolio You’ll Ever Own.  His new book, The Smartest Money Book You’ll Ever Read, is available from several retailers and in various formats, including: Amazon, Barnes & Noble, Nook and  iBooks.

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