Enhanced Tax-Efficiency With Private Placement Life Insurance

Private Placement Life Insurance (PPLI) can be a game changer for clients who have $1 million or more to allocate to alternatives and non-traditional investment strategies but are concerned about the substantial taxes they may incur.


A PPLI policy offers an effective way to achieve tax efficiency for this portion of their portfolios, and maintain a meaningful death benefit, without sacrificing potentially higher long-term returns.

 

Who are likely candidates for PPLI?


For the right client situation, the benefits of PPLI can be substantial.


PPLI policies are particularly compelling for individuals who want access to hedge funds, debt funds, and other investment strategies that typically generate highly-taxed income. PPLI can address their sensitivity to taxable income by having these investments reside inside a vehicle where growth is tax-deferred and a substantial income-tax-free death benefit is payable to the beneficiaries.


Other prospective candidates include family offices, non-grantor trusts, and business owners who experience a significant liquidity event when they sell their closely-held businesses.



 

The growth potential of alternatives with the tax benefits of life insurance PPLI is a type of variable universal life (VUL) insurance that offers:


  • The potential for tax-deferred growth in the policy’s cash value

  • Generally tax-free access to the accumulated cash value (via loans or limited withdrawals)

  • Tax-free transfer of wealth to heirs through the policy’s death benefit


But a PPLI policy also provides a tax-efficient solution for clients who are interested in the growth potential of certain tax-inefficient alternative investments and have a long-term investment horizon.


 

A tax-efficient solution for tax-inefficient investing


PPLI is unique in its ability to allow policy holders to hold tax-inefficient alternative investments within a tax-favored insurance structure, and thereby incur no immediate income taxes. (This also means that PPLI policy holders have no need to wait for a Schedule K-1 form from the investment fund to complete their annual tax filing.)


The PPLI policy owner/client can choose from an array of registered and non-registered investments to invest the cash value. These investments are available from the insurance carrier in the form of insurance dedicated funds (IDFs) which typically include private and public debt funds, hedge funds, real estate investment trusts, private equity funds, and commodity funds.


Private placement life insurance (PPLI) policy


Private Placement Life Insurance
PPLI

While IDFs are the most common investment choice for a PPLI policy’s cash value, insurance companies are increasingly offering separately managed accounts (SMAs) managed by a registered investment advisor as another investment option as well.


Because any growth of the investments inside the life insurance policy is not subject to current taxation, the policy owner won’t experience the drag on returns (or “tax friction”) that results from the taxation of dividends, income, and gains on securities that are owned outside of an insurance policy. So, even though the gains in the PPLI policy initially may be lower than if the money was invested directly in alternatives — due to the additional cost of providing the life insurance benefit — the insurance-related expenses of the policy are balanced by the substantial long-term income tax savings that the policy owner may be able to realize.


Over time, as the tax savings compound over many years, the spread/difference between the potential tax-deferred gains inside the policy and the highly taxed gains that would have been realized outside of the policy becomes even greater.


 

Comparing taxable earnings outside and inside a PPLI policy

Repositioning assets to reside inside a PPLI policy is an excellent example of the concept of “asset location” – a strategy that minimizes taxes by taking the least tax-efficient assets from a taxable environment to a tax-advantaged one.


For example [1], let’s say a client invested $1 million in an alternative debt fund, and each year that fund earns a hypothetical 10%, or $100,000. Depending on the client’s federal and state tax brackets, those earnings could trigger from 40% to 45% in taxes. That means the client could lose $45,000 or nearly half of their taxable gain to taxes. So, $100,000 becomes only $55,000. Now let’s say the client used that same $1 million to purchase a PPLI policy and selected an IDF that invests the policy’s cash value in similar debt instruments. With the benefit of tax-deferral, the client won’t pay the $45,000 in taxes, unless or until they withdraw any of the policy’s gains in the future. There is no “tax friction” inside the PPLI policy and their gains continue to compound over time, tax-deferred. Plus the client will have the additional benefit of a substantial amount of life insurance to protect their family and/or pass along to their heirs tax-free.


In order to obtain the tax benefits of the PPLI policy, of course, the client will have to pay the insurance-related charges – including the actual cost of the insurance coverage (mortality charges), deferred acquisition costs (i.e., the “DAC tax”), administrative charges, sales loads, and fees. If those charges are less than the amount they are able to save on taxes with their more tax-efficient cash value investments, then the PPLI policy may be the most cost-effective, tax-efficient choice.


PPLI is the more cost-effective insurance option when the amount you save in taxes by investing inside the policy exceeds the cost of the insurance policy over time.

On the other hand, if the client’s health or advanced age means that the cost of the insurance will exceed the potential tax savings, then a PPLI policy would not be appropriate.


As the chart below illustrates, the tax savings need to compound over a number of years in order to realize the benefit of deferring the income tax versus paying it currently.


Comparison of Investment Returns


Hypothetical Comparison of Taxable and Insurance-Embedded $10 MM Investments*

* Incremental costs for PPLI include Federal Deferred Acquisition Cost (DAC) tax, state premium tax, a structuring fee, cost of insurance charges, and policy administration fees.


If you surrender the policy in five years or less, there may not be a meaningful difference between having to pay current income taxes and deferring those taxes but paying for the cost of the insurance. Over a 15 or 20-year period, however, having a PPLI policy can yield a significant advantage.


This is why PPLI is most appropriate for clients who have an insurable risk and can sustain the insurance contract long enough to take advantage of the benefits of tax-deferred compounding of any growth in the policy’s cash value.

 

Two applications of PPLI’s benefits


The client scenarios [2] outlined below suggest why PPLI deserves a permanent place in your toolbox of specialized insurance-based planning solutions.


1. Tax savings + future funding for a family foundation


When properly structured, the ownership of a PPLI policy by a trust can achieve two important objectives at once by: 1) mitigating the effect of income taxes on asset growth over time, and 2) minimizing estate taxes.


In our first example, a husband and wife with substantial wealth were able to leverage the tax savings potential of PPLI policies while also creating a significant tax-free death benefit for their children and fulfilling their commitment to charitable causes.


The couple’s net worth was about $400 million and they had already transferred $25 million to trusts for each of their children. Unfortunately, those trusts were established as non-grantor trusts where each trust was responsible for paying its own taxes. The situation presented a perfect opportunity to eliminate the annual tax bill for the trusts by purchasing PPLI policies with trust assets. At the same time, the PPLI policies in the children’s trusts created a total of $80 million in death benefits.


In addition, instead of the entire estate going to the surviving spouse and incurring considerable estate taxes at the second death, the couple decided to make a testamentary gift of $300 million to their family foundation. While this meant that those assets would not go to their children, the couple believed that the $80 million death benefit their children would ultimately receive was sufficient and met their objectives.


In this case, the PPLI policies not only provided substantial tax relief. When used within the trusts and in tandem with other planning strategies, they also helped the couple achieve their estate planning and philanthropic goals.


2. Tax savings + survivor protection


The second example involves a corporate executive who had the benefit of a split-dollar survivorship life insurance program while he was working. When he retired, he wanted to maintain some level of insurance, but the current policy’s death benefit was too large to be supported by the cash value in the contract and future premium payments were not an option. In addition, the face amount was larger than what was needed to accomplish his estate planning goals. Surrendering the policy and investing the cash value was considered, but with a zero cost basis, surrendering it outright would incur a large tax burden.


Rather than surrender the policy and pay ordinary income taxes on the substantial gain, the executive’s advisor suggested a non-taxable (Section 1035) exchange of the assets from the old split-dollar life insurance policy to a PPLI policy.


The PPLI option provided an effective, customized way to preserve a portion of the original death benefit in the new policy while potentially maximizing its future tax-deferred cash value growth.

 

Requirements to maintain insurance benefits


Like all insurance contracts, a PPLI policy must comply with a number of IRS rules to maintain its tax benefits. For example:

  • An appropriate ratio of death benefit to cash value must be maintained at all times.

  • The fund choices available to the policy owner for investing the cash value must be specific to the policy and cannot also be available to the general investing public.

  • While policy owners can allocate their cash values among the available IDF investment options, they cannot control or influence the individual investments held inside each fund.

  • An IDF must meet a diversification requirement and include a minimum of five separate investments to qualify as life insurance.


Other Considerations:

  • PPLI is only available to individuals who meet “accredited investor” and “qualified purchaser” guidelines as defined by the SEC.

  • The amount of assets allocated to PPLI will vary depending on the client, but generally should comprise no more than 10% - 25% of an individual’s total assets.

  • A PPLI policy generally requires a minimum premium of $1 million, so it can be designed with lower administrative fees.

  • If the policy is surrendered, any appreciation in the value of invested assets will be taxed as ordinary income.

 

A valuable solution for the right client situations


Generally, PPLI is most appropriate for clients with substantial assets to allocate, a desire to access alternative investment strategies, and a desire to maximize the value of the assets transferred to their beneficiaries. But it can also be customized to address the needs of individual investors, family offices, funded trusts for children and grandchildren, and people with significant liquidity events who are seeking more tax efficient growth of their wealth.


Determining whether a PPLI policy is the right choice for a client requires carefully weighing the potential income and estate tax advantages of PPLI in light of the individual or business situation.


Our team is prepared to meet with you and your client to help you make this important – and perhaps “game changing” – decision.

 

[1] This example is for illustrative purposes only, and is not intended to serve as investment advice since strategy is dependent upon your individual facts and circumstances.


[2] All hypothetical client scenarios are provided for informational purposes only, and are not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.


Investments in securities involve risks, including the possible loss of principal. When redeemed, shares may be worth more or less than their original value. Investors should consider the investment objectives, risks, charges and expenses of any investment carefully before investing.


Private Placement Life Insurance is an unregistered securities product and is not subject to the same regulatory requirements as registered variable products. As such, Private Placement Life Insurance (or Annuities) should only be presented to accredited investors or qualified purchasers as described by the Securities Act of 1933.


Alternative investments, such as hedge funds within private placement life insurance, involve risks that may not be suitable for all investors. These risks include (but are not limited to) the possibility that the investment may not be liquid, principal return, and/or interest rate risk. Higher fees associated with alternative investments may offset any potential gains. Investors should consider the tax consequences, costs and fees associated with these products before investing.


Investors should consider the investment objectives and horizons, income tax brackets, risks, charges, and expenses of any variable product carefully before investing. This and other important information about the investment company is contained in each fund’s offering memorandum. Please read it carefully before you invest.


Market risk can be hedged through various means but it cannot be entirely eliminated. The hypothetical returns shared here are not guaranteed, involve risk, including possible loss of principal.


Neither M Financial nor its insurance advisers/agents are authorized to give tax, legal, or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.


An insurance contract’s financial guarantees are subject to the claims-paying ability of the issuing insurance company. Loans or withdrawals from your policy may impact your policy including your future death benefits. Please review your policy contract before taking loans or withdrawals from your cash value. Cash values and death benefits may vary based on the policy you purchased. Please consult your full policy illustration at the time of purchase. Cash value accumulation is determined by the policy contract and is not always guaranteed.


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