Be Your Own Banker: There is More to the Story

 Situation: Many of us are aware that life insurance enjoys several tax-favored benefits. Specifically, we know that unlike annuities, withdrawals from a life insurance policy are not taxable to the extent they do not exceed the cost basis of the policy. Furthermore, loans of any amount permitted by the insurance carrier can be taken income tax-free.1 Because of the tax-favored treatment of withdrawals and loans from a life insurance policy, many strategies promote accessing policy cash values either as withdrawals or loans.

One such strategy falls under the category of “be your own personal bank.” Unfortunately, many of the videos promoting the concept need to do a better job at explaining the full story. When considering the use of life insurance as a personal bank there are product features and tax aspects that should be considered. This Counselor’s Corner will provide guidance on some of the considerations that should be evaluated when there is a desire to access life insurance policy cash values

Solution: When you have a client that plans to access their policy cash values there are specific policy features you will want to pay attention to at the time the policy is purchased. Following are some of the key product features to examine:

• First, you must understand the carrier’s loan feature. Many carriers do not permit an owner to take a policy loan in the first year of the policy and there can be limits on the percentage of cash value an owner may borrow. Don’t forget the obvious, early in the life of a policy its cash value will typically be less than the amount paid. Therefore, you typically will not want to plan on borrowing from the policy in its early years.
• Also, you should have a clear understanding of the loan options (fixed, indexed, variable, preferred, “wash”), how often it can be changed, and how interest will be credited to the values associated with the policy loan. When taking policy loans, the relationship between the interest charged on a loan and the interest credited to cash values attributable to the loan is very important to understand to avoid unnecessary risk and policy costs.
• You may want the policy to have an overloan protection rider that, when elected, will prevent an unwanted policy lapse. It’s important to understand the limits of this feature. Often this feature may be exercised only after an insured has attained an advanced age and may only be available on policies structured using the GPT (guideline premium test) structure.
• If the product is a flexible premium structure you will want to decide which life insurance definitions to use – GPT (guideline premium test) or CVAT (cash value accumulation test).2 The GPT life insurance definition structure has historically been used to minimize mortality drag providing more cash value growth opportunity. However, with the recent tax law changes this difference between GPT and CVAT is not as great. GPT is often the “default” in carrier illustration software, so if you want to use CVAT you will want to make sure to request or change your illustration proposal to CVAT. Advisors should note that unlike the CVAT definition, the GPT definition limits the amount of premium that can go into a contract. This can create a Catch 22 if a policy needs premium to avoid a lapse caused by significant policy loans. The CVAT definition provides more premium flexibility.
• It’s important to recognize that significant policy loans can cause a policy to lapse. If the policy is in a gain position at the time of lapse this will cause the policy owner to recognize “phantom” taxable income – meaning the owner will owe taxes on the policy gain but will not have cash from the policy which to pay the taxes.
• Consequently, it may be helpful to run the illustration with lower assumed crediting rates to see how the product performs.

When using life insurance as a personal bank it’s important to not just consider the product features; you also need to avoid the tax landmines. The two most common ways to lose the favorable tax treatment of life insurance involves heavily funding a policy such that it is classified as a modified endowment contract, or a cash rich policy as described below.

• Modified Endowment Contract. One way the tax-favored treatment of life insurance can be lost is by paying too much premium during the first seven years of the contract (or in the 7-pay period after a material change), causing the policy to be classified as a modified endowment contract (MEC). Death benefits from a MEC is still generally received income tax-free under IRC § 101(a). However, lifetime distributions from a MEC are taxed differently than distributions from non-MEC policies. Common policy distributions include withdrawals, loans, and assignments. Distributions from a MEC are taxed as income first and recovery of basis second. Furthermore, the portion of any distribution that is included in the policy owner’s gross income may be subject to a 10% tax penalty if the policy owner is under age 59 ½.
• Withdrawals from a Cash Rich Policy. Another way the tax-favored treatment of life insurance can be lost is by violating what is sometimes referred to as the “cash rich rules.” In general, the rules affect policies with large premiums relative to the death benefits that are issued or exchanged after 1984. According to the cash rich rules, anytime there is a cash withdrawal from a policy that results in a reduction of the death benefit within the policy’s first fifteen years there is a possibility that some portion of the distribution will be subject to tax. In the first five years of a policy the amount that can be withdrawn in a heavily funded policy is the most restrictive.

Fortunately, it’s possible to avoid unfavorable tax treatment with a little advance planning. First, if the policy becomes a MEC because of excess payment, the insurance carrier is required to notify the policy owner and provide him/her an opportunity to request a refund to avoid MEC status. It should be noted that there are situations where excess premium payment is required to keep the policy in force. If excess premium payment is required to keep thepolicy in force, options specific to the client will need to be explored. Obviously, if the desire is to use the policy as a personal bank you will want to make sure it does not become a MEC.

The best way for your clients to avoid problems created with distributions from a heavily funded cash rich policy is to ask the carrier to perform a cash rich test prior to taking a withdrawal to determine if any part of a proposed distribution will be subject to income tax.

Alternatively, you can have the client wait until year sixteen before taking a withdrawal because the cash rich rules do not apply once you are past the 15th policy year. Finally, if waiting is not an option, your client can take a policy loan prior to year 16 because policy loans do not typically reduce the policy death benefit; thus, they do not trigger cash rich testing.

In Summary. When using life insurance as a personal bank it’s not only important to avoid the tax land-mines, you also need to consider the practical things like the impact changes in crediting rates and loan assumptions can have on the long-term viability of the policy. For example, recently I reviewed an illustration where a mere .7% decrease caused the policy to lapse at the insured’s age 83. Even more problematic the policy would not accept additional premiums because the proposal used designed using GPT. Unable to prevent the policy from lapse, the insured would end up recognizing significant phantom income. While an overloan feature may prevent the lapse on an 83 year-old insured, it must be elected with most carriers. If the policy is not being monitored by a knowledgeable financial professional the client may not be aware of the elected option. Bottom Line: When using life insurance as a personal bank the policy performance must be stress-tested at time of issued and continuously monitored after the sale to avoid unexpected landmines.