The internet is full of crackpots and knaves.
And this is especially true of financial newsletter writers attempting to grow their subscription lists by giving misleading or downright fraudulent investment advice.
My inbox has been deluged of late by several newsletter writers advancing the idea of a retirement plan based on the Tax Reform Act of 1986.
The writers are calling these plans by several names, such as the “770 Plan,” “702(j) Plan,” or “Income for Life.” Of course, there are no such plans in existence. These writers are simply attempting to prevent potential subscribers from searching google for the tax code reference (U.S. Tax Code Title 26 Subtitle F Chapter 79 Section 7702: Life Insurance Contracts).
In short, a 7702 plan is a life insurance contract. More specifically, it’s a life insurance policy in which a death benefit is combined with a living benefit (savings account). The plans are known as whole life insurance.
Now, by definition, whole life insurance policies are not investments. It is a violation of insurance laws to call any life insurance product an investment or retirement plan. Just ask Prudential Insurance Company of America which was forced by regulators to pay $2.7 billion in restitution to more than a million customers. What were Prudential agents doing?
They were selling whole life and universal life insurance policies as retirement plans. And to convince buyers to take action, the agents used policy illustrations that projected outrageous interest and dividend accumulations as foregone conclusions (insurer dividends are paid only by mutual insurers and are not equivalent to stock dividends). In the 80s, it wasn’t uncommon to see agents use policy illustrations showing potential returns of 12% – 15% on a life insurance policy. It was patently absurd.
To fight this type of fraud, a whole slew of laws were passed more than a decade ago to prohibit insurers and agents from selling life insurance as an investment or retirement plan. Today, any agent or insurer engaged in any such activity is violating the insurance code of every state.
At this point it’s important to draw a distinction. I’m not saying there are no legitimate uses for whole life insurance to provide income in retirement. Like other financial products, life insurance is a tool in the bag of a financial professional to accomplish specific goals of an individual or business.
But, there is no whole life/universal life insurance product sold in the United States that can be called a retirement plan or investment. No exceptions. Period.
So this begs the question…
How are these newsletter writers promoting a life insurance policy as a retirement solution?
To answer that question, you must have a basic understanding of how a whole life policy works (a universal life policy works almost identically with a few exceptions that aren’t relevant to our discussion).
A whole life policy consists of two components – a death benefit and a living benefit.
A death benefit pays a sum of money to a beneficiary in the event of an insured’s death. The cost of the insurance protection is based on the insured’s age at the time the policy starts. Whole life insurance is relatively expensive (about 450% – 600% more expensive than term life insurance).
The living benefit is nothing more than a savings account attached to the policy. The policy is designed so that the cash value will be equal to the face amount of the policy at age 100 (the maximum age for life insurance).
This means that if an insured survives to age 100, an insurance company will write a check for the face amount of the policy. For example, a 45-year old man buying a $500,000 whole life policy will receive a check for $500,000 should he survive to age 100. The policyholder will owe taxes on the amount of the payout that exceeds the cost basis of the policy.
As you might expect, the interest grows relatively slowly over the life of the policy. Insurers contractually guarantee minimum interest rates in the policy, but they rarely exceed 2% – 4%. Interest credited to the account is tax deferred similar to interest accruing in a qualified retirement plan such as a 401(k) or IRA.
In addition, policyholders can ‘borrow’ the cash value at any time. The policyholder can use this money for any purpose without regard to taxes. This is because borrowed money is not taxable. On the other hand, if the policyholder fails to pay back the loan with interest, the amount of the loan in excess of the cost basis is taxable. If a policyholder dies before paying the loan back, the insurer will pay the beneficiary the face amount of the policy less the loan amount and any accrued interest.
Of course, the odds of a man living to age 100 are not very good. So if the insured should die before age 100, the insurer will pay the beneficiary the face amount of the policy – $500,000 in the example used above. Death benefits on a lump sum distribution from life insurance are not subject to income taxes. But if a beneficiary chooses an alternative payout (i.e. interest only or period certain), the interest portion of any payout would be subject to tax.
Now, when average Americans buy whole life insurance, they do so on a forward basis. By this, we mean the agent helps identify the amount of insurance protection an individual needs and designs a policy around those needs. The agent attempts to provide the maximum protection based on the insured’s ability to pay premiums.
Here’s where newsletter writers diverge from the norm…
You see, they promote the purchase of life insurance on a reverse basis. That is, they advise buying a whole life policy based on the amount of premium an individual can pay with no regard to the face amount of the policy. It is most commonly done by businesses and older wealthy clients.
Here’s how the plan works…
An insured makes large payments into a whole life policy for between five and ten years on average. We’re talking about large payments that frequently range from $5,000 to $50,000 annually.
To keep the policy legal (as an insurance contract), an insurer must provide a death benefit commensurate with the annual premiums. For example, a 60-year old man could deposit $50,000 with an insurer. To avoid the deposit being treated as an investment under current law, an insurer would have to provide a death benefit to the insured.
In this case, the death benefit might be roughly $600,000 depending on the health of the insured. So the insured immediately owns a whole life insurance policy of $600K with an instant cash value of some $43,000. The policy will mature 40-years later at age 100.
Now, you might ask why the savings account doesn’t have the full $50,000. The answer of course is agent commissions and the cost of the insurance protection.
But the policyholder now has $43,000 that will grow tax deferred. In addition, the policyholder could borrow the money from the account without incurring a tax liability. Should the owner borrow the entire $43,000 of cash value and fail to repay the loan, no tax liability would be incurred because the loan proceeds are less than the cost basis ($50,000).
In future years, the owner could make additional payments. After five or more years of additional payments, including earned interest and dividends (mutual insurer only), the owner will likely have a policy with a cash value equal to or greater than the amount deposited.
In addition, the face amount of the policy will also be higher to maintain compliance with the modified endowment contract rules (7-Pay Test). These are the rules that the Tax Reform Act of 1986 created that require equilibrium between cash values and death benefits in whole life insurance.
Of course, the policyholder can borrow the cash value while alive without incurring a tax liability. But remember, should the loan not be repaid, taxes will be owed on any loan proceeds in excess of the cost basis. In the event of death, a beneficiary would receive the face amount of the policy less any loans and accrued interest.
At the end of the day, whole life policies are tools for accomplishing specific financial planning goals. But whole life policies are wholly inadequate for retirement planning. The costs make these plans financially inefficient. They weren’t designed to fund a retirement and make a poor substitute in doing so.
Life insurance was developed as a method of transferring risk of premature death. Any calls for using whole life as a retirement plan are short-sighted and potentially illegal. Run, don’t walk from anyone espousing these plans as a way to get rich in retirement on a tax-free basis.