Private placement life insurance (PPLI) is a wealth protection strategy that can help individuals in higher tax brackets protect their assets.
It is considered a more viable alternative to hedge funds as it is not subjected to the same type of taxation. When wealthy individuals invest in hedge funds using their personal name or a trust, every trade made by the fund’s manager can result in a capital gains distribution. Moreover, their ordinary income is taxed at a very high rate. For some people, capital gains taxes, state and federal income taxes can add up to close to 50 percent of their earnings.
By holding their assets in a life insurance policy instead, these individuals can avoid the tax burden of a hedge fund. Here is a look at how it works.
Private Placement Life Insurance: The Basics
Privately placed life insurance is typically structured as a variable universal life insurance policy. This means that it comes with flexible premiums that can be paid at the amounts the policyholder wishes at the time of their choosing. However, they must pay enough premiums to ensure it keeps a sufficient cash value for covering the cost of the insurance, which will be deducted from the policy subaccounts’ cash value on a monthly or yearly basis. Should the cash value of such a policy drop to zero, it will lapse.
Most clients pay as much premium into their private placement life insurance policy as they can as it will be set up to maximize its cash value accumulation and keep the death benefit on the lower side.
These policies give holders a tax-deferred cash value growth and a tax-free benefit for their heirs. They may also offer tax-free dividend growth. Moreover, these policies do not have required minimum distributions.
Accessing The Money In A PPLI
Holders will not be subject to penalties if they attempt to access their policy’s cash value prior to age 59 ½, which is not the case with individual retirement accounts and annuities. They can access the cash value at any age and for whatever purpose they choose, and they can also choose to borrow from it.
Here is a closer look at the two main methods of accessing the funds in a PPLI.
Policyholders can enjoy tax-free withdrawals up to the basis of the policy itself. This means they can get back their premiums, minus any applicable fees, without suffering any consequences from a tax standpoint as long as their subaccounts have performed in line with the insurance cost. Should the cash value be more significant than what the owner has paid in, the additional withdrawals beyond that basis will be taxed as gains.
Policyholders may borrow against their policy’s cash value without an underwriting or credit check. Because the loan is secured by the cash value of the policy, it is a good source of emergency funds. Although the loan does not need to be paid back, policyholders often elect to replenish any funds that they borrow from these policies to maximize the long-term tax-free growth that they set it up to enjoy in the first place.
Loans against these policies typically come with very low-interest rates because they are secured by the payments that have already been made to the insurer. However, interest accrues, and borrowing does reduce the death benefits that will be paid out if the loan is not paid back to its policy.
To help ensure that life insurance is genuinely used for its intended purpose rather than as a tax shelter, the government has set limits on how much premium a policyholder may contribute in a given year. Contributions are subject to the seven-pay test. This means that should a policyholder contribute enough premium that the policy would be fully paid in less than seven years, it converts into a modified endowment contract that is not eligible for many of the tax advantages that apply to withdrawals and loans.
With a modified endowment contract, loans from the policy are taxable as income, and withdrawals before the age of 59 1/2 will face a 10% early withdrawal penalty.
What Makes Private Placement Life Insurance Different From Retail Life Insurance?
Although privately placed life insurance may be very similar to conventional variable life insurance policies from a structural standpoint, the assets held in a PPLI subaccount are fully customizable. Policyholders may choose whatever type of investment they desire, including hedge funds and index funds. With retail life insurance, customers may select from a limited choice of subaccount investments that are chosen by the life insurance company.
Discuss Your Wealth Planning Strategy With Vector Financial Group
To learn more about how a private placement life insurance policy can help you take advantage of tax benefits and protect your finances, contact Vector Benefits to speak to one of our specialists.