It’s broadly expected that income and capital gains taxes will increase, especially for high earners. It’s a waste of time to speculate on the specifics but Matthew Hague has a handy summary of the largest proposed changes. If you are a high-earner in CA or NYC, you’re looking at all-in income taxes well north of 50% as well as an increase in capital gains taxes. Naturally, you want to know what tools are available to minimize the tax burden. In this post, I will relay what I have learned about insurance as a tool for allowing investment returns to compound tax-free.

I’ll start with a caveat. You should be skeptical.

A common impression of insurance companies, is they sell you coverage that you often never use and have no idea if they will find fine print to weasel their way out of paying out benefits. The salespeople are cringe. The industry is huge and a poster-child for regulatory capture, beholden to powerful lobbyists. And even despite the heavy regulation, a bunch of bumbling Michael Scott-types found their way to the front page of the WSJ during the GFC when they fancied themselves option traders (via CDS).

I’m with you. I have lots of doubts about insurance. When someone tries to pitch you on permanent (ie whole-life) insurance it’s best to tell them to beat it. You are perfectly capable of “buying term and investing the difference”. But something I cannot dismiss, is that there are wealthy, financially sophisticated investors with large insurance policies. Then a loved one, also an investor, who was also dismissive of insurance started digging. So much so that he got a license to structure policies for his family as well as his 3 siblings’ families commission-free. Combine all this with 2 interesting developments in the tax and insurance world, and it was time to start calling people in my network to help me learn.

This post is a summary of my discoveries. I’m not a tax/insurance pro, so I disclaim everything. I wanted to get everything down on paper both for my own reference and for any readers that are interested in taking the baton. Insurance has hard-to-value trade-offs. But if you have substantial savings, it is worth learning more. This post is what I know so far.

Reviewing Basic Tax Hygiene

There are simple, well-established practices for allowing your investments to compound tax-free.

• Use tax-advantaged accounts to hold interest-bearing or dividend-paying investments (ie IRAs, 401ks, 529s)

• Focus on after-tax returns. Private investments that trade frequently generate short-term gains. Active mutual funds will also. ETFs allow you to decide when you sell, so you can shift your decision to a “long term” gain where tax rates can be significantly lower than ordinary rates.

• Borrowing against large portfolios to fund spending, to avoid triggering capital gains. This is a standard playbook for rich insiders who are confident in their company’s prospects and don’t want to interrupt compounding with cap gains. If you have a large diversified portfolio on a platform like Interactive Brokers, you can use portfolio margining to borrow at attractive rates without needing to liquidate holdings. This is a form of leverage, which comes with its risks you need to evaluate.

• The real kicker to the borrowing method is that when you pass away, your holdings receive a “stepped-up” basis essentially crystallizing a lower overall tax burden for your heirs.

While the tax code is about to get more fluid (potentially threatening stepped-up basis and rules around loans collateralized by stock holdings) until now these techniques have been standard.

The use of permanent insurance has also been well-understood. However, compared to the techniques listed above, it incurs more brain damage, expense, opacity, and coordination (often involving agents, advisors, and lawyers and especially when trusts are come into play). The good news (or bad news, depending on your perspective) is that you wouldn’t bother exploring this unless you have enough assets to make it worthwhile. My goal is to provide enough context, so you can even have a hint as to whether it might be worthwhile.

Insurance As A Tax-Advantaged Account

The way life insurance works is you pay annual premiums in exchange for a tax-free death benefit when you pass. If you die suddenly, the insurance company takes a bad beat. You may have paid a small amount of premium and received a big benefit. If you live to 100, you likely abandoned your policy at some point because it became to expensive or you just didn’t need it anymore and the underwriter keeps your premiums. The actuaries balance this risk/reward. With term insurance, this is all straightforward. It’s like buying a put option on your life with a fixed premium for a fixed expiration date. You must naturally pay a premium over the actuarial odds, but insurance is a competitive industry so you can expect they are reasonable. If your family’s life with be financially wrecked by the loss of your income, you should insure against that.

Permanent insurance combines term insurance with a savings vehicle. Investopedia explains:

Unlike term life insurance, which promises payment of a specified death benefit for a specific period of years, permanent life insurance lasts the lifetime of the insured (hence, the name), unless nonpayment of premiums causes the policy to lapse. Permanent life insurance premiums go toward both maintaining the policy’s death benefit and allowing the policy to build cash value. The policy owner can borrow funds against that cash value or, in some instances, withdraw cash from it outright to help meet needs such as paying for a child’s college education or covering medical expenses.

There is often a waiting period after the purchase of a permanent life policy during which borrowing against the savings portion is not permitted. This allows sufficient cash to accumulate in the fund. If the amount of the total unpaid interest on a loan, plus the outstanding loan balance exceeds the amount of a policy’s cash value, the insurance policy and all coverage will terminate.

Permanent life insurance policies enjoy favorable tax treatment. The growth of the cash value is generally on a tax-deferred basis, meaning that the policyholder pays no taxes on any earnings as long as the policy remains active.

As long as certain premium limits are adhered to, money can also be taken out of the policy without being subject to taxes because policy loans usually are not considered taxable income. Generally, withdrawals up to the sum total of premiums paid can be taken without being taxed.

Because of the savings vehicle embedded in permanent insurance, the premiums are higher, but much of that premium belongs to the policyholder and accrues to the cash value of the policy. That excess premium can be invested for tax-free growth.

The basic identity:

Cash Value = Premiums + Returns – Costs

Permanent insurance usually falls in one of these categories:

1. whole life: the excess premium are invested in low-risk fixed income instruments for a more predictable return

2. variable life: the premiums are invested in mutual funds

3. indexed-life: the returns are tied to the performance of an index but protected from loss (like a structured product which uses option collars. The fund overwrites call options to finance the purchase of puts)

These policies have a bad rap for good reasons.

• They have expensive commissions, often front-loaded, meaning that your cash value will lag the premiums invested for several years before catching up. You are immediately underwater, and if you wanted to stop paying premiums, you have incinerated the money.

• You are taking the insurance company’s credit risk.

• The investment options are more limited than the full menu you might find at any large broker.

Again the sensible advice for most people is “buy term, invest the difference”. But let’s see why your situation might warrant a closer look.

First, we need to back up a few decades.

The History Of A Very Consumer-Friendly Policy (Loophole?)

Permanent insurance is a strange Frankenstein. Many public investment products, especially the type offered by an insurance company, are commoditized, unbundled, and subject to highly competitive fee pressures. Why would you want to then bundle an investment with your term insurance? It goes back to the taxes. Remember, the policies grow and payout tax-free. Of course, everyone understands this. It’s the crux of the slimy broker’s pitch. Insurance products are hard to price and evaluate, so the agent has lots of room to structure a policy that maximizes the underwriter’s profit or may simply be unsuitable for the client (the worst case, is a common case — the policy is too large and the client eventually throws in the towel on the premiums, causing the product to lapse before it accumulates).

So if you want to properly take advantage of the IRS’s tax-free growth loophole, you need to understand how to structure a consumer-friendly policy. The key to this is to construct the policy from the outset so it is built for accumulation and minimizes the actuarial insurance cost. Remember, you are not interested in the life insurance portion of this product. You are trying to stuff as much money into the policy to grow tax-free. Like sticking an unlimited amount of savings into a Roth IRA.

Wealthy people understood this idea 50 years ago. In the 1980’s, rich investors were overfunding policies by egregious amounts. So they might have a $5mm death benefit which would might incur annual premiums on the order of $5k or $10k but they might stuff hundred of thousands of dollars into it. Finally, the IRS wisened up and passed the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). This act changed the landscape by creating Modified Endowment Contracts or MECs. A heavily overfunded  would be considered a MEC and lose much of its advantaged tax status.

Here’s Investopedia:

This act created the MEC. Before this law was passed, all withdrawals from any cash-value insurance policy were taxed on a first-in-first-out (FIFO) basis. This meant the original contributions that constituted a tax-free return of principal were withdrawn before any of the earnings. But TAMRA placed limits on the amount of premium that a policy owner could pay into the policy and still receive FIFO tax treatment. Any policy that receives premiums in excess of these limits automatically becomes a MEC.

Suddenly, these super consumer-friendly tax loopholes did not make sense for investors who wanted to access the cash during their lifetimes. The death benefit still allows the holder to pass the proceeds tax-free to their heirs, but with penalties and taxes associated with loans and withdrawals, these policies only make sense for the ultra-rich without liquidity needs.

The Non-MEC Policy

MEC rules work by limiting how much you can stuff into a policy for a given level of death benefit¹. Don’t hold me to make-believe numbers, but to be allowed to stuff $5mm of premiums into a policy, to not trigger MEC designation, you might need to purchase a policy with a $20mm death benefit. The actuarial cost of that life insurance, eats into your investment returns.

The key to structuring a consumer-friendly policy that avoids MEC designation. Remember, if the policy is treated as a MEC then you cannot withdraw or borrow against the policy tax-free because you lose FIFO tax treatment. So you want to start with how much premium you want to invest in this tax-free structure then find the minimum amount of death benefit you need to buy to make sure the policy doesn’t classify as MEC.

The IRS uses a “corridor rule” to determine that the death benefit is high enough for a given level of premiums to ensure that the policy still looks like an insurance contract and not simply a stealth Roth.

Investopedia again:

There must be a “corridor” of difference in dollar value between the death benefit and the cash value of the policy.

Private Placement Life Insurance Expands Your Investment Options

There are many types of mutual funds and annuities permanent insurance policies can invest in. But if you prefer to hold private investments in an insurance wrapper you will need to look at private placement life insurance or PPLI. Before explaining how PPLI works, I’ll start with why I wanted to learn about it in the first place.

Why PPLI Could Be Worth Exploring 

In continuing my theme of skepticm regarding insurance as an investment, I will say that PPLI is even less relevant to most people. Still, my own interest in it was prompted by 2 developments, one of which is now moot, but it’s still worth discussing.

1. IRAs disallowing private investments
   
   The recent tax proposal seeks to limit wealthy individuals from using tax-advantaged accounts to avoid paying Uncle Sam (thanks Peter Thiel for pulling the ladder up on the regular 1-percenters… everyone else can put their tiny violins away now). The proposal would ban any investment requiring “accreditation” from being custodianed in an IRA.²
   
   If you have private investments that are trading-oriented and generate short term cap gains, you would need to divest them from your IRA. Many of these investments live on the lower absolute return/higher Sharpe’s spectrum so paying taxes annually on the gains would be make them significantly less attractive. PPLI offers a tax-advantaged way to hold them.
   
   (As of October 28th, the revised proposal has since slashed this restriction. The proposal will continue to require earlier RMDs or required minimum distributions for IRAs with over $10mm in assets can theoretically still make PPLI a workaround for those people. again, we are getting to even smaller numbers of people who are going to care about this.)
   
   

2. The amount of premium you can put into these policies for a given level of death benefit has doubled
   
   In December 2020, the IRS lowered the interest rate assumptions used in the construction of permanent insurance. This means you do not need to buy as much of a death benefit for a given level premium. The “corridor” has narrowed. If you used to need to buy a $40mm death benefit to invest $5mm in PPLI, now you only need to buy $20mm death benefit for that same $5mm of investment. This lower the actuarial cost of insurance over the life of the contract.

With PPLI seeming like the only viable way to hold high turnover strategies and the cost of maintaining a policy falling, I looked into what they can actually hold.

Investment Options Within PPLI

PPLI policies allow 2 main channels to invest.

1. IDFs and VITs
   
   Insurance policies cannot directly invest in mutual funds or private funds. The management of such funds needs to create another entity to accept insurance feeders. If the fund is public, this can be done via a VIT or variable insurance trust. I just think of them as a share class that accepts funds from insurance policies. The analog on the private side is IDFs or insurance dedicated funds. For example, your insurance policy can invest in Millennium's IDF. Izzy Englander’s fund is a good example of a fund that makes sense for a tax-advantaged entity because its annual gains are going to be treated as short-term profits.
   
   Be aware:

   • To access VITs or IDFs the platform you subscribe to PPLI with needs to onboard them

     • IRC Sec 817(h) is a diversification mandate which effectively require you to hold 5 investments
       
       

2. Advisor mediation
   
   If you want to choose investments that are not available via IDFs or VITs then an advisor must make the selections for you on a discretionary basis. While your investment statement define criteria for their choices, you cannot directly instruct the advisor’s choices. Lack of agency here is a drawback.
   
   

[If you run an investment fund you should take note. Any increase in tax rates makes PPLI more attractive on the margin. I expect assets held by insurance policies will grow. If you are a GP of a fund with many retail, especially HNW, investors it’s probably a good idea to explore creating a VIT or IDF feeder for your fund.]

While PPLI still maintains the above restrictions on what can be invested in, the menu is growing and the primary advantage over conventional permanent insurance structures is access to private investments.

Costs

The good news is you can access directly PPLI platforms directly, there’s no broker or insurance middleman.  But this process isn’t cheap. In addition to a couple thousand bucks for the health exams, you can easily rack up $20k in attorney fees to setup the structures depending on how complicated your estate is.

Then there are the costs directly associated with the policies. There fall in two categories. One-time costs based on premium invested and ongoing maintenance costs. Let’s break these down.

1. One-time premium-based expenses
   
   

   • DAC or “deferred acquisition charges”
     
     This is a flat 1% federal tax on the premium put into the policy. It’s like a one-time government load.
     
     

   • Premium tax
     
     This is a state tax on the premium amount. Most are between 1.75%-2.5%. South Dakota has one of the lowest premium tax rates if you hold the policy in a trust or LLC (2% on the first $100k, .08% on everything else). 
     
     

2. Ongoing expenses
   
   

   • Mortality and Expense fee
     
     You can think of this like an AUM fee. It’s about 40 bps annually based on the cash value of the policy.
     
     

   • COI or cost of insurance
     
     This is the actuarial premium paid for the death benefit you receive. This is about 15-20 bps annually for a healthy individual. 
     

To think about the fees over the life of the contract you can spread the premium based fees over the life of the contract. If you are 40 and live to 80 the premium-based fee add little drag since you are dividing say 2% over 40 years, and that is only on the initial invested premium not the growth. 

When you model out, both sets of fees you see in the insurance proposals, it ends up costing you about 70bps per year. Is 70 bps good or bad? 

First of all, that is 70 bps in addition to the expenses or fees charged by the underlying funds. But assuming your comparing to private funds you would have invested in via a non-tax-advantaged account, that is a wash.  So whether the 70 bps is a good deal depends on your returns. If you earn 8% gross, but would have paid 300 to 400 bps in taxes annually, than 70 bps is a good deal. If the gross CAGR of your investments is only 3%, than you are not saving much. So you can think of the 70 bps as a hurdle to be compared with the tax drag of the counterfactual portfolio. 

Evaluating that 70bps is downstream of soul-searching you should be doing anyway, “Are these private investment options worth it?“

Not For Everyone

Between the costs and consideration of pros/cons of illiquid private investments in the first place, it’s pretty clear PPLI is only worth exploring if you checked yes at every node of the gauntlet. While most PPLI policies are non-MEC (indicating that the holders expect to either drawdown or borrow against the policy’s cash value in their lifetime), there is still a significant proportion that is MEC. This suggests that many holders are families who never expect to need these millions of dollars and preferred the flexibility to allocate substantial sums to a policy quickly, violating tests that would permit non-MEC status.

While I laid out the basics above, in reality, the holders of such policies are combining them with trusts to preserve generational wealth. Platform minimums are about $2mm (for a non-MEC policy imagine a household funding $500k/yr for 4 years corresponding to say a $20mm death benefit). But the typical policy holder is probably stuffing away more like $5mm-$10mm and has a net worth in the tens of millions.

Wrapping Up

My little dive into insurance topics was driven by:

• the specter of higher taxes. I live in CA so my family gets smoked on taxes as it is.

• the threat of changes that would have required us to divest funds requiring accreditation from our self-directed IRAs. Many of those investments, are not tax-efficient so holding them outside a tax-advantaged structure would force us to reconsider the allocations entirely.

• the realization that my friends who run funds should consider whether they should have IDF or VIT feeders

Insurance is not a fun topic. I’m more of markets guy not a Marty-Bird-structuring-type-of-guy. It makes my head hurt. The layers of fuzzy risks plus costs present many trade-offs. Overall, it felt worthwhile to consolidate and organize my notes from reading and phone calls into this post.

Again, this topic is outside my wheelhouse, so if I’ve made errors or you have questions, please reach out. We are learning in public together.