Executive Summary
Many readers of this blog contact me directly with questions and comments. While often the responses are very specific to a particular circumstance, occasionally the subject matter is general enough that it might be of interest to others as well. Accordingly, I occasionally post a new "MailBag" article, presenting the question or comment (on a strictly anonymous basis, of course!) and my response, in the hopes that the discussion may be useful food for thought.
In this week's MailBag, we look at how to structure an advisory firm that is aiming to be an RIA and help clients to implement their insurance needs (using an insurance broker general agent relationship to avoid working with a broker-dealer), and the tax consequences of a life insurance policy when the insured dies while there is still an outstanding loan against the policy.
Offering Insurance Solutions As An RIA With An Insurance Broker General Agent (BGA) Relationship
Question/Comment: What are your thoughts on advisors who are wanting to switch to RIA, but still want to work with clients through the insurance planning (since we do all the planning here anyway)? Seems like there aren’t really any good “no-load” options for high end insurance. Have you seen some that set up a separate company for insurance planning through a broker-dealer?
Operating as an RIA with a separate insurance relationship or affiliate is definitely a legitimate option, if you have the depth of knowledge and experience and really want to help clients with the insurance implementation. I’ve actually suggested this blend of RIA-plus-insurance can be a particularly effective business model when working with younger clientele, who tend to need a unique combination of ongoing planning advice, plus insurance needs (e.g., term life insurance as clients start family, disability insurance, and even assistance getting health insurance through the exchanges and planning around the premium assistance tax credit). And as you note, the world of no-load life [and other] insurance has tried several times to get going but never seems to gain much traction. There simply aren’t a lot of strong no-load insurance options out there. And if the clients go to another insurance agent, or even just a website, they’re still going to pay the same price, because the insurance commission (or more generally, the insurance marketing and distribution cost) is already built into the cost.
That being said, it’s worth noting that just because clients need the insurance coverage doesn’t mean you have to be the one to implement it. Your clients may need mortgages from time to time, but you probably refer that out to a mortgage broker you trust, rather than brokering the mortgage yourself. Your clients need wills, trusts, and other estate planning documents, but you probably refer that out to an estate planning attorney you trust, rather than doing the legal documents within your own advisory firm. So when your clients need insurance on occasion, is it really necessary to do that yourself, as opposed to referring it out to a trusted insurance professional, just as you refer out to other affiliated professionals in other situations? If you’re really providing value with your advice, let your clients pay you for that advice, and work with trustworthy and quality professionals who can add value in their areas of expertise, who are compensated in the manner that fits their services. You don’t have to get paid for every possible point of implementation, whether it’s the mortgage, or the wills and trusts, or the insurance.
It’s also important to bear in mind that if you’re operating as an RIA but also offering insurance solutions, you should not be holding yourself out as a fee-only advisor (which you may or may not be doing already, although I know it is popular for those who operate as an RIA), especially if you are a CFP certificant. Offering “fee-only” services through an RIA while simultaneously providing insurance solutions as a part of your comprehensive financial planning is a violation of the “fee-only” term under the CFP Board’s compensation disclosure definitions – that was the exact issue that landed Jeff and Kim Camarda in hot water and spawned the 2-year lawsuit with the CFP Board that is just now winding down. And while there has been a great deal of criticism of some details of how the CFP Board applies its compensation disclosure rules (including from yours truly), in this regard I think the CFP Board is absolutely right – if clients really are compensating the advisor both ways, make sure that is appropriately disclosed, and don’t plan on marketing yourself as fee-only.
Nonetheless, the fact remains that a number of firms are implementing this combination approach, whether because they simply want to benefit from the revenue of the insurance commissions, or because they feel it’s the best way to execute a holistic model of wealth management. Ironically, the recent debacle where 9 out of the top 10 CNBC “Fee-Only” firms actually receive insurance commissions is just another illustration of how common this approach actually appears to be amongst large RIA firms serving high net worth clientele. On the other hand, if the concern is just making sure that the client is well served by a 'good' insurance agent, there are also a number of third-party insurance brokers now who work constructively with fee-only advisors and do solely insurance (so they're not "competitors"), including Low Load Insurance Services, Ryan Insurance, Insurance Decisions, or NextGen Advisor for life insurance, or MAGA LTC or the Natovitz Group for assistance with long-term care insurance.
One final point to bear in mind, though – as also illustrated within the disclosures from the top CNBC firms list – is that if you are going to implement the insurance yourself, but you're using "just" life, disability, and long-term care insurance, and you’re not specifically recommending variable life policies, you don’t actually need a broker-dealer relationship (and all the hassle that entails, including the push of many B/Ds to try to oversee and take a slice of your outside RIA business). All you actually need is a relationship with an insurance broker general agent (BGA) that can support what would be entirely fixed insurance product solutions. And if you’re working in the high-net-worth space in particular – where the typical insurance cases are large and fairly lucrative for all involved – you’ll likely find a number of BGAs that would be willing and interested to work with you.
Treatment Of Life Insurance Policies With A Loan Outstanding At Death
Question/Comment: I'm looking for information on what happens when a life insurance policyholder dies with a policy loan outstanding. I'm thinking there may be some adverse tax consequences caused by the loan?
The treatment of life insurance loans are sadly a common source of confusion these days.
The reality of a life insurance loan is that technically, it is little more than a personal loan from the insurance company to the policyholder, for which the cash value and death benefit of the life insurance policy is collateral. This is why a life insurance policy with a loan lapses if the outstanding balance of the loan gets too close to the current cash value – in essence, it’s just the insurance company foreclosing on the insurance policy collateral to pay off the loan before there’s any possibility that the loan could go underwater. And of course, it’s easy for the insurance company to execute, since it both manages the loan and controls the insurance policy collateral!
The fact that a life insurance policy loan is really just a personal loan for which the life insurance policy is collateral also explains why the lapse or surrender of an insurance policy with a loan can trigger a taxable event.
Example 1. Imagine for a moment that you have a policy into which you paid $50,000 of premiums, but the policy’s cash value has grown to $90,000 thanks to favorable returns on the cash value. The policy also has a loan against it, which has compounded to a balance of $85,000. The net value of this relationship is $5,000 (the $90,000 cash value less the $85,000 loan), but if you surrender the policy, technically you’re still surrendering a $90,000 cash value (with a $50,000 cost basis), using the $90,000 of surrender value to pay off an $85,000 loan, and then receiving the $5,000 remainder. Which means even though your policy is only “worth” $5,000 in the end, you’ll still owe a tax bill for $40,000 of gains.
The key distinction in the scenario above is to recognize that notwithstanding the presence of a personal loan for which the insurance policy is collateral, the fact remains that it is a life insurance policy with a $90,000 value and a $50,000 cost basis that has a $40,000 gain. The fact that you used (or were contractually obligated to use) the policy proceeds (including the gain) to pay off a personal loan was a separate matter. It was still a policy with a gain. The same is true when you have a mortgage against a house and you sell the house for a gain and use the proceeds to pay off the mortgage; you still have a taxable gain, even if the net proceeds after paying off the mortgage are small. Of course, with a mortgage the loan is generally being paid off while the house appreciates, so the equity usually increases… while with a life insurance policy, the loan can accrue interest, leaving little equity in the policy (even though the gain still looms large).
In the context of death, however, the situation is a little different. It is still true that there is a personal loan with the insurance company, for which the policy’s cash value and/or death benefit is the collateral. What changes is that when the insured dies, the policy’s death benefit is paid out tax-free, under the standard rules for tax-free death benefits of life insurance under IRC Section 101(a).
Example 2. Continuing the prior example, assume that the life insurance policy with a $50,000 cost basis, a $90,000 cash value, and an $85,000 loan, has a $150,000 death benefit. Upon death, the policy generates a tax-free death benefit of $150,000. The first $85,000 of that death benefit is used to pay off the $85,000 loan, and the remaining $65,000 is then paid to the stated beneficiary.
In this scenario, there is no income tax event associated with the loan at death, because there is no income tax event associated with the life insurance policy itself. The death benefit is paid out tax-free – simply by virtue of being a life insurance death benefit – and the tax-free proceeds are then used to pay off the (personal) loan, with the remaining proceeds paid out to the beneficiary.
So the good news here, in the context of your original question, is that dying with a life insurance policy with a loan does not create an income tax issue, because the loan is implicitly repaid from the tax-free death benefit of the insurance policy itself. In fact, the irony is that from the tax perspective, this is actually the outcome that many policyowners with a big loan “hope” for – because if the policy stays in place long enough to mature as a tax-free death benefit, the loan can be repaid tax free from those death benefit proceeds (and may actually have a very appealing internal rate of return if held until death!), but if the policy lapses before that point (perhaps because the loan compounded to the point that the insurance company was forced to foreclose), the policy’s surrender/expiration while the policyowner is still alive means the taxable gain comes due (even if there’s little or no net equity remaining)!
Excellent summary Michael. I would clarify that under IRC 101a, life insurance proceeds are generally received income tax free (ignoring transfer for value consideration and exceptions thereof). Note the phrase “income” tax free, however not necessarily estate tax free. If ownership of the policy is included as an asset within an estate taxable-estate, the death proceeds may be exposed to both state and/or federal estate taxation-when the taxable estate exceeds applicable exemption limits. Careless ownership of large policies owned within an estate can oftentimes trigger estate tax liabilities, particularly at the state level. The federal exemption amount (which is indexed annually), is $5,430,000 for 2015.
Strategies are of course available to either mitigate or entirely eliminate the potential estate tax inclusion exposure issue.
Frankly, there is no reason to be an insurance broker unless you want to collect commission income from the transactions. There are so many great brokers out there, as listed by Michael, that having an insurance license is not really a great use of a CFP’s time, in my opinion. I dropped my Insurance license long ago, and work with great brokers to get the best information and deals for my clients. Most of which, by the way, need nothing more than term insurance with a reasonable death benefit. Variable or whole life policies are usually overkill.
A high dividend paying whole life policy (tax deferred IRR of 5% on current policy cash values) provides a highly desirable rate of return for a stable asset within one’s total portfolio, and can be used as a cash buffer for emergency funds, along with tax free withdrawals of both cost basis and gain, to fund long term care insurance policies, another linchpin for a secure retirement. Many of my sagacious CPA clients will readily volunteer that their 20-30 year old whole life policies, represent one of the finest assets they have ever acquired.
Policy cash values can also be borrowed against in poor equity markets, allowing equity positions time to recover. This approach raises the inherent rate of return on one’s entire portfolio.
Policy cash values may also be borrowed against for emergencies, thereby reducing the need to set aside large amounts of cash into low yield 1% cash-money market type assets. Again, this approach raises the overall portfolio rate of return for retirees.
Tax deferred cash values accruing at 5% tax deferred are far superior to 1% money market cash reserve funds, again raising the entire portfolio rate of return for retirees.
Finally, a permanent life insurance policy premium is of course higher when compared to a term policy because with a whole life policy, you are purchasing capital on an annual installment basis which you OWN, versus a term policy wherein capital is merely rented for a period of time designed to expire before an Insured dies.
This means that not only will a permanent death benefit be received by a beneficiary in retirement (to replace loss of SS retirement benefits), but will also replenish portfolio losses due to poor equity market returns along with poor investor or advisor advice and errors.
Wise Owl, the problem I have with most whole life policies is that they do not provide sufficient death benefit especially to young families. It’s not feasible for most folks to pay for the $2M in death benefit they will need until they are 65 through a whole life policy. So I see too many people under-insured because they were sold only a whole life policy and no term insurance to fill the death benefit gap. Michael you are welcome to jump into this discussion for a future mailbag article…
It’s not one or the other, it’s typically both isn’t it?
Large jumbo term policy for estate creation purposes earlier on in life, large permanent coverage for post age 45-50 range.
Great advice!! As an independent insurance broker in AZ, I make it clear to my clients that I offer fixed insurance products. I specialize. Should they require investment advice or are seeking a variable product, I have several trusted advisors that specialize in these areas to who I refer often. In turn, these advisors refer their clients to me when a fixed insurance product is appropriate for the portfolio. We both feel good knowing we are acting in the best interest of the client, and the client knows this. This leads to stronger relationships and better results for everyone.
A BUSINESS OWNER BUYS A COMPETITOR OUT OF BUSINESS, AND IN THE PROCESS GETS OWNERSHIP TWO KEY MAN POLICIES ON THE LIVRS OF FORMER OWNERS, THEY HAVE TAKEN MAXIMUM LOANS ON THER POLICIES , IF THE NEW OWNER SURENDERS HTE POLIIES AND THERE IS A TAXABLE EVENT IS HE LIABLE FOR THE TAX CONSDEQUENCE, SINCE THE PREVIOUS OWNERS ARE IN POSSESION OF THE LOAN PROCEEDS? THEY HAVE THE CASH AND HE HAS POLICIES WITH MAX LOANS, WILL HE BE RESPONSIBLE FOR THE TAX IF HE SURRENDERS THE POLICIES EVEN THOUGHT HE WILL NOT RECEIVE ANY CASH?