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The Tax-advantaged Income Plan

If you like Roth IRA’s, you are going to love this strategy – what we refer to as “optimally funded IUL.” The primary reason is that it allows a policy owner to take a stream of tax-advantaged income. However, unlike a Roth there are essentially no limits on how much you may contribute, as long as the premiums fall within IRS guidelines. Additionally, there are no age 59½ rules to complicate things. This strategy is only possible because of special tax treatment provided for in the Internal Revenue Code. IRC section 7702 and 72e permit the cash values in universal life policies to accumulate tax-deferred, with the option that the policy owner can withdraw them at any time without creating a taxable event. In the event of a death, the withdrawals reduce the death benefit. Because this strategy is non-qualified (non-IRA), it allows us to design a plan with virtually any amount of money that meets the needs of our client. [1]

So, how does it work?

Life insurance cash values are made up of two parts, the paid premium, referred to as the basis, and stock market index gains. While the gains grow tax-deferred, it is important to note that taxes are still paid on the basis, before the money is contributed to the account as ordinary income. When the policy owner desires to turn on the stream of income from the cash value, it is done in two distinct phases.

First, withdraw tax-free income from the basis until it is depleted.

Then, borrow the gains and pay only loan interest with no income tax.

This sequence is important because Universal Life Insurance is one of the only contracts the IRS allows the policy owner to withdraw the money paid in (the basis) before gains. This unique tax advantage is unlike other investments where the tax code requires the withdrawal of the gains before the basis. Accountants refer to this accounting method as FIFO – First-In-First-Out.

The insurance contract that our firm utilizes for this strategy is called Indexed Universal Life Insurance (IUL), and we use it because it has many valuable features. It provides the policy owner with the potential for tax-deferred cash value accumulation, as well as a tax-free death benefit. In addition, a properly structured, optimally funded IUL policy can protect the owner from losses due to the volatility of the stock market. This strategy is an innovative life insurance approach that takes advantage of the tax code and protects the cash value accumulation from market volatility during both the growth and payout phases.

In summary, the contract allows for,

  • Tax-deferred accumulation
  • Tax-free income at retirement, or any other time, for any purpose
  • Equity indexed returns linked to the performance of the S&P 500, DOW Jones, NASDAQ, etc.*
  • Cash value gains are locked in each year with protection from stock market declines
  • Access to available cash values at any time
  • Greater flexibility and control than a Roth
  • Tax-free death benefit
  • No Probate at the time of death

This strategy is ideal for,

  • Parents and grandparents who want to build a college fund for children and grandchildren
  • High-income earners who have maxed out their 401(k) or other retirement contributions
  • IRA owners who want to build additional retirement income above IRA limits
  • Small business owners who cannot afford to provide a qualified retirement plan

More than ever this strategy has become a valuable tool for today’s planning needs.

However, this strategy may not be suitable for all investors. Because this strategy utilized a life insurance policy, additional fees may apply that may not be necessary if you do not intend to use the life insurance feature. Please consult with a qualified tax advisor to determine if this is the best strategy for you.

*returns credited to the basis of the contract are only linked to the performance of the index, however they do not own an actual investment in the index or any of the securities the index is comprised of.


[1] A “Modified Endowment Contract” (MEC) is a tax qualification under the federal tax laws of a life insurance policy that has been funded with more premium than allowed. A MEC changes the order of taxation for money withdrawn from the contract, and may penalize the policy owner for withdrawals before age 59½. A life insurance contract that becomes a MEC is basically treated like a non-qualified annuity by the IRS for taxation purposes - prior to the insured’s death. The death claim can still be tax-free even if the policy is classified as a MEC.

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