Drain the Usual Suspects: Can Overfunded Life Protect HNW Clients from Coming Tax Rises?

Drain the Usual Suspects: Can Overfunded Life Protect HNW Clients from Coming Tax Rises?

We stand at the tree line, all silent for a moment, waiting to cross the fateful valley.

I’m not talking about Faulkner’s fantasy of Pickett’s Charge at Gettysburg, the moment when good Southern boys could say, ‘it hasn’t happened yet’, and still live their unfortunate dream. If you think a son of Massachusetts whose great-grandad served in the United States Colored Troops harbors any unreconstructed fantasies… pardon me. I do rattle on with my family stories.

Apologies to anyone offended but I leap on my soapbox when prompted, if simply by myself. Yet the simile is fine for a post about taxes. They’re coming, likely for everyone as a gasoline tax, most certainly for the wealthy, unfashionable as the Rebel yell today. It hasn’t happened yet, HNW folks. Still time to do what I would, if I awoke in Robert E. Lee’s gray ranks on a bare Pennsylvania hill. That is, run like a scalded fox in the other direction.

You’ll need to be foxy. We’ve been living in low-tax country for a while now, enjoying globally low pump prices, though everyone complains. I once filled the tank of a quail egg-sized rental in Turkey, paid $75 equivalent for the privilege, and drove away wondering if I’d been cheated – they saw the Greek coming. My girlfriend of the hour, Christina from Udine, on hearing the bill, offered: “Should we go back? I think we underpaid.” Twice that in Italy, she said – we’ve had it good in America, for a while.

Get ready for the new deal, small caps. The accumulated deficit is creeping toward $25 trillion. We hope economic growth can save us, but if you run up a tab like that, expect a stern talk from the bartender-lender. Deep pockets will need to be dug into for hard cash, and guess who gets rifled first?

It isn’t exactly unfair, but avoidable suffering makes no sense at all. My father never used novacain, sniffed at the dentist’s drill, thought I was dainty for taking the needle. Yet biting the bullet merely crushes your teeth. Here in the modern world,  we have options to limit our agony, taxes included.

We’re not planning for the short term. Taxes will rise for the next decade or more, bet on it. The current administration could be out in four years, sure; Congress could change hands even sooner; it happens. One trillion dollars in $100 bills weighs 2.2 billion pounds. No matter who takes the reins, there’ll be a weight on their backs. Expect them to shift it to us.

Let’s start with the hopeful. Wealthy clients can use their 401(k) and IRA potential to the maximum. They can invest in a health savings account, or HSA, paid with pretax money that earns tax-free interest. These are nice options.

But there’s one problem with qualified plans: the contribution limit. The IRS knows we’re keen to avoid their acquaintance. They work to prevent us from using retirement plans as investment vehicles with tax-limiting features, hence the annual contribution limits. For example, in 2021, the Roth 401(k) limit is $19,500 if you’re under age 50. Those older can pay $6,500 more as a ‘catch-up’ contribution. HNW clients may find these restrictions do not match their tax-slimming ambitions.

There’s another strategy that can suit wealthier clients: overfunding life insurance. It’s simple in conception but tricky to execute and their tax, estate and insurance planners will need to sit down. I like the idea – one more arrow in your quiver to skewer the tax bill – yet I’m concerned at the minefield of misinformation I’m finding online.

Here’s the bare bones: the policyholder chooses a permanent life policy and aims for the smallest death benefit feasible for their case. The aim is to minimize the cost of funding the death payout and policy expenses. There is no premium payment limit – well, that’s what you’ll hear, but stick around for the qualification – and customers can technically pay as much as they like, thereby overfunding the policy. These excess premiums flow into the cash account, rapidly activating and maximizing its benefits.

In a variable life policy, this can maximize potential returns, and with whole and universal policies, the bigger the cash balance, the greater the possibilities for the owner to exploit it, legally and tax advantageously.

Permanent life insurance offers feature that qualified retirement plans can’t match. There’s the death benefit, insurance’s ultimate tax-free investment. Policyholders gain tax-free growth in the cash account, which can be withdrawn or borrowed against without the age limitations that restrict qualified plans. The owner can take loans using the policy as collateral, and the loan funds are tax free. Once retirement is achieved, cash value withdrawals that don’t exceed the policy basis are tax free, too.

It all sounds… well,  I won’t say a no-brainer. Sharp minds, Detective Colombo quality, are needed on this case. That ‘no-limit’ feature is commonly touted, but in fact, there are limits and they’re dangerous to cross. The rules even trip up insurance agents sometimes, which is why wealthy clients need a team, where someone will ask that ‘oh, just one more thing’ question, saving the day.

What can go wrong? One false step and you’ll end up a MEC. Pay a little too much in premiums and your beautiful life policy pumpkins into a Modified Endowment Contract. It’s bad. You lose the first in, last out basis that allowed tax-free withdrawals. Any loans taken are now taxable income. Early withdrawal incur a 10% penalty tax. The MEC morph is permanent: there’s no way to drum the life policy back into tax-dampening service. Suddenly, you’re a sugar mommy or daddy for the IRS.

The practical limit on overfunding permanent life policies is determined by the 7 Pay Test. A quote from the IRS rule might do us right now, so we know the animal we’re up against:

“A contract fails to meet the 7-pay test if the accumulated amount paid under the contract at any time during the first 7 contract years exceeds the sum of the net level premiums which would have to be paid on or before such time if the contract were to provide for paid-up ‘future benefits’ (as defined in ­­ 7702A(e)(3) and 7702(f)(4)) after the payment of 7 level annual premiums.”

Insurance companies generally tell clients when they’ve paid too much and the MEC is rearing its heads. Fair enough, but if I were HNW, I’d rather know all before launching the endeavor. OLI isn’t something to plunge into headlong. This strategy calls for long-term commitment, careful funding and deep understanding by all involved. You’ll be digesting lots of spreadsheets before you decide, I’m sure.

This doesn’t make the overfunded life insurance strategy a Dodo, and for the right customer, it’s golden. I fear ordinary folks may resent my touting this idea solely for the wealthy. It’s a kicker, but only for punters who can afford a crack team to advise them and keep all in order. Wealth opens opportunities that only the rich can access, true – yet with burdens only they can bear.

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