Tax rates are currently at or near historic lows. But ask just about anyone and the expectation is that taxes are sure to increase in the future. So, finding tax-efficient shelters for wealth accumulation is important for protecting long-term portfolio value and accomplishing tax planning goals. For the ultra-wealthy, private placement life insurance (PPLI) can provide powerful tax benefits while helping investors maintain liquidity. Here’s a quick look at how private placement life insurance can provide a valuable tax shelter for a variety of asset classes.
What is private placement life insurance?
Private placement life insurance has the same basic components and follows the same IRS rules and restrictions as other cash value life insurance products. However, unlike more generic retail insurance products, pricing is individually negotiated and the policy itself is highly customizable. Likewise, the costs to investors associated with PPLI policies can be much more efficient if designed properly (more on that below).
Benefits of private placement life insurance
The real value of private placement life insurance is the flexibility it provides in terms of the asset classes a person can own within their policy.
In a standard, off-the-shelf life insurance policy, the permanent product has an underlying cost of insurance. But a policy holder can pay that cost and also add value that exceeds that cost to create a surplus cash value within the contract. That value can be handled in a number of different ways.
In some policies, insurance companies will offer a fixed interest rate based on the value of the contract. Gains from that interest accumulate within the policy on a tax-deferred basis, providing predictable growth. In other policy types, investors can allocate along a list of predetermined investment choices such as sub-accounts that behave like mutual funds, index-linked options with banded returns, or variable dividend rates based on carrier performance.
This is where PPLI differs and where its real value lies.
In a PPLI contract, investors are not beholden to a pre-determined list of investment choices. As long as the policy meets certain requirements for liquidity and diversification, investors can own private equity, real estate, individual stocks and bonds, and many other security types.
This has significant tax planning benefits because:
1. Assets held within the life insurance policy are not subject to income tax
- This is the biggest benefit of private placement life insurance, giving investors a tax shelter for assets to grow in a tax-free environment. Also, transactions are not subject to capital gains tax, because unlike taxable brokerage accounts, realization events do not create a taxable event when using PPLI. So, by minimizing the cost of insurance and maximizing contributions to increase the cash value of the policy, PPLI gives the ultra-wealthy a tax-efficient vehicle to protect assets and accumulate wealth, as long as the insurance cost is lower than the tax drag in an otherwise taxable account.
2. Investors still have immediate access to cash value
- PPLI provides better liquidity than off-the-shelf insurance products, essentially offering immediate access to the principal if needed. Cash value access rules are the same, allowing investors to withdraw their basis and values above their basis through the use of policy loans.
Using PPLI to preserve generational wealth
While an investor is alive, PPLI provides a very tax-efficient vehicle to manage and grow wealth. But it can also help protect and facilitate generational wealth as well.
If a policy holder has funded a grantor trust or irrevocable trust for their children, all of the assets within that trust are already considered outside of their estate for estate and transfer tax purposes. But those assets don’t get a step up in cost basis like assets do inside the estate at death. So, at death, an investor’s heirs would inherit the original basis and have a tax liability associated with liquidating those assets. Essentially, the investor would have avoided transfer taxes, but not income taxes on funding those trusts for beneficiaries.
However, this situation can be avoided using PPLI. Investors can fund a grantor trust with the same money but instead of managing it in a taxable environment, put it inside a PPLI contract. Then, at death, the policy pays the death benefit, which is generally equal to the value that was in the contract. But because of IRS rules, the death benefit pays income tax-free to beneficiaries. So, an investor would have preserved that step-up in basis on assets held outside their estate, potentially providing exceptional value to beneficiaries.
Making the most of tax-efficient solutions
The economics of private placement life insurance are such that it isn’t a viable solution for just anyone. But for the ultra-wealthy, it can provide valuable tax planning benefits by shielding a wide range of asset classes from income and capital gains taxes. PPLI also allows investors to maintain liquidity and exercise more control over investment decisions. Altogether, PPLI can represent a valuable tax-efficient solution that should be considered as part of any comprehensive tax planning strategy.
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