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Impact On Alternative Investments As Income Taxes Increase

With the specter of higher federal income and capital gains taxes looming large due to unprecedented government spending and budget deficits, individuals with substantial assets are looking for ways to manage the impact of tax increases on their investment gains – now and in the future.

Higher income and capital gains taxes are very likely as the federal government seeks ways to reduce a deficit that has grown exponentially due to spending on the Covid-19 pandemic. These tax increases will likely affect all working Americans but may place an even greater burden on wealthier individuals and their families.

U.S. Federal Government Budget Surplus/Deficit ($Millions)

Source: Office of Management & Budget. Income tax rates do not include the 3.5% net investment income tax.

Sample Client Scenario

George Lee is an experienced investor who has a need for life insurance protection and is comfortable investing in hedge funds, private equity, and other alternatives which offer the potential for greater returns along with greater risk.[1] At the same time, he is worried that those returns will be dramatically reduced if capital gains taxes increase.

He knows that directly investing in alternatives:

  • is inherently not tax efficient because he must pay annual income taxes on capital gains generated by high turnover and on any imputed (“phantom”) income

  • can incur heavy management fees, and

  • will require filing for an income tax extension while he waits for his Form K-1s.

A solution: a private placement life insurance (PPLI) policy that manages risk and allows unique access to insurance-dedicated alternative funds.

Unlike traditional life insurance policies which often employ conservative strategies to investing a policy’s cash value, a PPLI policy gives wealthy individuals access to hedge fund investments with the tax efficiency and risk management of life insurance. The tax-deferred growth and tax-free death benefit proceeds that life insurance offers may be particularly attractive to investors who are concerned that rising capital gains taxes will further erode their earnings on alternative investments, which are already notoriously tax inefficient.

How a PPLI policy works

PPLI policies are usually variable universal life insurance policies that invest in alternatives such as venture capital, hedge funds, real estate investment trusts, private equity funds, and commodity funds. Because these insurance-dedicated funds are embedded inside the life insurance policy, the funds are able to accumulate on a tax-deferred basis inside the life insurance contract.

The value of embedding alternatives in a life insurance policy sub-account

As the charts below illustrate, using insurance-dedicated funds inside of a life insurance policy eliminates the immediate and ongoing taxation of gains on alternative investments, significantly increasing the short-term returns and long-term value of George’s overall portfolio. In this hypothetical example, the net rate of return on the investments after taxes is 6% when the funds are embedded in the PPLI sub-accounts, versus 3% outside of the insurance policy.

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.

Summary of PPLI benefits:

  • Customized product structuring and sub-account options

  • Separate accounts for policy assets that are not subject to insurance company credit risk

  • Tax-deferred accumulation of sub-account returns

  • Income tax exempt death benefit proceeds (including accumulated gains) for future generations

  • No Form K-1 reporting requirement

But remember, with PPLI:

  • The policy owner must pass Qualified Purchaser and Accredited Investor rules.

  • All of the sub-account funds available are approved and managed by the insurance carrier.

  • Although they may choose to have assets accumulate in any of the alternative sub-accounts the insurance company offers, policy owners have no direct control of the alternative funds held within each sub-account.

  • If a PPLI policy is fully surrendered, the deferred investment gains within the policy are subject to tax at ordinary income rates.

Take the next step now

Our firm has the expertise and experience to help you implement complex, tax-efficient wealth management solutions that take advantage of life insurance products specifically designed and priced for clients with substantial assets. These solutions can help you:

  • Seek higher returns and lower taxes – with death benefit protection – while building assets for the future

  • Adjust your portfolio for potentially volatile markets

  • Prepare for anticipated changes to estate and gift tax policies

Schedule a time to talk with us. You can also download our private placement insurance guide to learn more.

[1] This hypothetical scenario is provided for informational purposes only, and is 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, and involve risk, including possible loss of principal.

TRC Financial is not 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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