Part 11 in the series will discuss an important financial strategy known as an "Insured Retirement Plan" or IRP.  If you would like to go the beginning of the series on "Learning more about Life Insurance than your Insurance Agent knows" click here to go to Part 1.  If you would only like to go back to Part 10, click here.

I alluded to the opinion that I have that UL (Universal Life) only makes sense for certain strategies – the Insured Retirement Plan (IRP) is one of these such strategies.  Before I go into the mechanics of how the policy works, I will explain the net effect: when set up properly an IRP allows you to accumulate funds in a tax sheltered environment and then USE those funds without triggering ANY tax consequences whatsoever – in effect a TAX FREE RETIREMENT.

Okay, sounds to good to be true right?  Well there’s lots of fine print to be sure, but these policies are set up all the time – especially with high income earners.  If you hated paying tax the first time you received a paycheque, wait until you get to the highest marginal tax bracket where basically half of your income goes to taxes – you will quickly and readily seek out tax planning strategies. All right…on to how it works!

Due to the math and calculations involved (which I will spare you) you need to know that such a plan has a "sweet spot" when it comes to the right prospective client – normally this person is 40-55 years of age, a high income earner with a desire to save on taxes and a need for insurance.  And of course, they must be insurable as well… You HAVE to get an insurance professional to run through software calculations to really determine and model what such a strategy would look like for your own personal situation.

(I have been asked for more information regarding why the sweet spot is 40 – 55 years of age to setup a plan like this.  I will address this at the end of the post.) 

So we start with a UL policy.  Normally what happens is we determine how much money can be set aside on a yearly basis to go towards the premiums for this policy.  Then we calculate how much insurance is required such that the maximum allowable premium (actual cost of insurance plus maximum allowable overfunding) equals the amount of cashflow the policy holder wants to direct to this strategy.  The overfunding continues as much as possible for as long as possible, normally until retirement.  Since the investment side account is tax sheltered we know it is growing faster than in a non-registered environment.  And since the policy holder is grossly overfunding the UL policy we know the investment side account will grow to an amount that far exceeds the amount required to fund the "underpayment" of the policy in later years.  So we have a large surplus sitting in this tax sheltered environment.  Now the goal is to access these funds after they have been accumulating in the tax sheltered environment for a long period of time.  BUT – we know that if you go in and directly access the funds – you cause a taxable event and you have to pay taxes on your gains.

Enter the second phase of the IRP.  Instead of taking money right out of the investment side account, you pledge the Investment Side Account (also known as the Cash Surrender Value) as collateral for a loan from the bank.  Normally banks will allow you to take out a loan of about 75% of the total value of the investment side account.  When you take out a regular loan from the bank the money you receive is not taxable income and the same holds true here.  The bank will give you this large loan because they know that you have the means to pay it back.  They normally require that you add an irrevocable beneficiary designation to the UL policy stating that when you die part of the Life Insurance proceeds are used to pay off the loan.

But oh, there is more! With normal loans you have to start paying back the loan immediately.  Remember I mentioned above that normally no more than 75% of the value of the Investment Side Account can be taken out? The reason for this is that you can structure the loan such that you do not make any repayments while you are alive.  The bank will still charge interest and it will compound since you are not even making the minimum interest payments – so if you take out a "policy loan" (as they are referred to) for $100,000 and the bank charges you 7.2% interest, then the rule of 72 tells us that after 10 years you will owe $200,000.  Your investment side account plus the actual life insurance coverage you chose will more than cover this in the future when you die.

You can also request a series of policy loans – i.e. instead of taking out $100,000 all at once, perhaps you take out $10,000 per year for 10 years – this will reduce the total loan balance you will have to repay when you die.

So let’s fast forward to when you die.  You have an outstanding loan to which you have never made a repayment towards, and a UL policy with a face amount of life insurance coverage PLUS the value of the investment side account.  The total benefit is split as follows: the bank gets their loan to you paid off first, and the rest of the money is distributed to your beneficiaries. Since life insurance benefits (including the value of the investment account) are tax-FREE if the benefit is paid, you will never have paid tax on your contributions to the investment side account, NOR on the growth of those investments.  The loan will be paid off (meaning your funds used were completely tax free) and then the remaining proceeds to your family are also tax-free.

Let me break down the whole IRP concept from the beginning as a summation.  You take out a UL policy.  You over fund the required premiums in order to contribute your savings into a tax sheltered investment side account. The investment side account grows on a tax sheltered basis.  Once you require funds at some point in the future, you pledge the value of the investment side account as collateral for a loan from the bank.  You never have to make payments against the loan while you are alive, and the loan balance increases over time.  Your investment side account is also increasing over time as well.  You get to spend the loan proceeds as you wish, and do not have to pay tax when you get the loan. When you die, part of the Life Insurance benefit (which is made up of the insurance coverage plus the investment side account) goes to pay off the loan from the bank completely, and the rest is distributed to your beneficiaries.

This is only one advanced strategy involving Universal Life insurance, but it is perhaps the most prevalent.

With respect to why the prospective investor would be 40-55, it has to do with mortality basically.  You need to start early enough so that you have time for the side investment account to grow to a satisfactory level.  You don’t want to start too early, otherwise you may exceed the limits of the value of the investment side account.  Remember, the government imposed rules about how much the value of the investment side account can be with respect to the level of insurance you have – this maximum amount is know as the MTAR line (pronounced "em-tar").  It stands for "Maximum Tax Actuarial Reserve".  If this happens, then excess savings above this line are basically forced into a fully taxable high interest savings account.  In addition, you may be forced to stop contributing to the investment account. And the reason why you can’t start when you are older is that it becomes less efficient in that the pure cost of insurance grows exponentially as you get older – so if you have a monthly budget of $1000 to spend on the strategy, maybe most of that will get eaten up by the pure cost of insurance since you are older. 

I will complete this series in the next article, Part 12: how to determine how much insurance coverage you actually need, and how much of it should be Term insurance (or temporary insurance, i.e. the cheaper kind) and how much of it should be Whole Life (or permanent insurance, i.e. the more expensive kind).  Pretty much the only time you need UL is for advanced strategies that have more to do with tax planning and investing than with providing protection and liquidity like Term and Whole Life are used for. 

CLICK HERE TO GO TO PART 12 

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