IUL can produce meaningful cash values to be used during the lifetime of the insured as supplemental retirement income, or to support the policy’s death benefit after premiums have been discontinued. In my May 11, 2012 blog I illustrated how IUL might be used in lieu of a Roth IRA. In the example used, a 35 year old pays a $5,000 annual premium for 20 years for an IUL policy that initially provides a $444,451 death benefit. By the time the insured is age 65, based on current assumptions, that death benefit grows to $547,000. But, death benefit would not be the main feature of this policy. A much larger death benefit could have been provided by the $5,000 annual premium. This policy was also to provide tax-free retirement income. Based on current assumptions, premiums could be discontinued at age 65 and the insured could start receiving $25,000 per year tax-free, through age 100. Plus, there would also be a tax-free death benefit whenever he died.
The premium for the policy illustrated was the maximum allowed without creating a Modified Endowment Contract (MEC). IUL functions very well as a vehicle that can produce tax-free accumulation of earnings and tax-free access to those earnings. Life insurance death proceeds are received free of income tax. Life insurance policies that are not a MEC can also produce tax-free income during the life of the insured. This is because tax treatment of withdrawals from non-MEC life insurance contracts are treated as “first-in-first-out” and policy loans are never considered a taxable event, unlike annuity policies. In our example, $25,000 would be withdrawn for the first 4 years and then after the $100,000 cost basis was recouped, subsequent disbursements would be made by policy loans. As long as there is enough cash remaining in the policy to keep it from lapsing, the loan would ultimately be paid off by the death benefit and no income tax would ever be paid.
If, upon reaching age 65 our 35 year-old insured didn’t need the income, the policy could merely continue without future premiums and, based on current assumptions, the death benefit would continue to increase.
IUL policies perform best when the premium is maximized to take advantage of the investment aspects of the contracts and to minimize the percentage of premium being absorbed by policy charges, which are usually higher than traditional UL policies. Are there some cautions? Oh yes! And that’s where we go on my next entry.
Next…managing your IUL policy and tiptoeing through the IUL illustration minefield.