​A common story we hear from potential clients is that they have had an unpleasant financial experience recently or at some point in the past. One rampant story involves said client speaking with someone who they thought was a full-service financial advisor and was going to help provide them financial guidance or specific advice/management pertaining to their investable assets. Instead, they spoke with an insurance agent applying pressure to buy a permanent life insurance policy with a cash value component[1]. Not exactly what the client was asking for, and probably not what they needed either. Does that necessarily matter to the agent who is going to be paid a rather substantial commission for their sale of the product?

This is a problem. It’s a problem for us, because it’s not the reputation we want our industry to have. More importantly, it’s a problem for the public in terms of advisors not determining a person’s needs adequately or providing them important education on financial instruments, strategies, or philosophies that advisors are using to secure the person’s financial future.

We don’t have an issue with insurance agents, nor do we have an issue with these types of permanent insurance policies per se. However, we do have a problem with professionals providing a piece of the puzzle to unknowing individuals leading to a transaction that is now misunderstood and has potentially negative consequences. Furthermore, these professionals seem to apply such attributes and products as if these practices should apply to nearly everyone. In our opinion, these insurance policies do not even apply to a fraction of whom they are sold to.

Permanent policies have a purpose. For example, we can support the idea of a person with wealth above the federal tax exemption limits (currently $5.45 million individually for 2016[2]) wanting to make certain that beneficiaries receive an inheritance tax-free via a death benefit. In some circumstances, we can get behind a permanent policy designed to protect the insurability of a young child. Or perhaps to secure financing in a buy-sell agreement in a business deal. We can even support the idea of a small policy like this being used for an individual’s burial funds if that individual doesn’t have the discipline and/or fortune to be able to save on their own.

More commonly we see insurance agents acting in the capacity of a financial advisor, who have sold a policy like this for other purposes that don’t make sense to us. They sell based on taking advantage of emotions, saying “You will guarantee a death benefit to your loved ones…and don’t you want to make sure they are taken care of?” Or, “You don’t want them to worry about your final expenses coming out of their pockets, right?” and they then may take it one step further by stating “A permanent policy gives you the best of both worlds…an investment and life insurance!”, even though there are alternatives to achieving this.

The one we have heard the most as of late is to have a policy to “borrow from yourself tax-free”. This is a concept that we find is misleading to the public that we plan to address further on in this post. We continually push people to ask questions and re-think what they have been taught or have experienced as it pertains to personal finance. An advisor should be more than a salesman placing you in a product. They should be a continuous resource and educator. If you align yourself with the right financial guidance, then learning healthy habits can create saving practices for burial costs and provide the legacy you want to leave behind to your beneficiaries in a more cost effective and efficient manner instead of paying inflated premiums to a life insurance policy until you pass at age 85.

What do you need to know to protect yourself from an advisor who says life insurance is a vessel that should be used as a liquidity vehicle to fund retirement income or for general needs?

  1. You are not borrowing from yourself, you are borrowing from the insurance company.
  • While the loan is tax-free, it is viewed as a personal loan, which all personal loans such as a credit card advances, cash-out refinancing’s, or even personal loans from a bank fall within the same camp. When taking money out of the cash value from your policy, you are receiving a personal loan from the insurance company. Yes, that’s right, you do not own the cash value, the insurance company does.

2. As with any loan, you’re going to pay interest.

  • The interest on the loan can vary depending on the institution issuing the policy. We often hear “I am not paying any interest”, which may be true. However, if you’re not, don’t fret, it will accrue over time. Oh, and did we mention, the interest rate is most likely not cheap.

3. The insurance company uses the cash value of the policy as collateral.

  • Meaning, at some point you will be repaying the loan either through outside funds, surrendering the policy and using the cash value to pay the loan back, or at your death the insurance company will use the death benefit to pay the loan back and the remainder will go to your beneficiaries. And you can’t forget if you do surrender the policy, be aware, there may be a penalty.

Now that we know we are borrowing from the insurance company, we can explain how this may be disadvantageous to an individual. Take the recent case of Kenneth L. Mallory and Larita K. Mallory v. Commissioner of Internal Revenue for example. Mr. Mallory purchased a modified single premium variable life insurance policy in October 1987. The single premium cost $87,500, and allowed Mr. Mallory to borrow from the insurance company securing the loans with his cash value policy. From roughly 1991 through approximately 2011, Mr. Mallory took loans ranging from $1,000 to $12,000 at a time. In December of 2011 Mr. Mallory received a letter from the insurance company stating his debt to cash value had exceeded his limit and in order not to lapse the policy he would have to pay $26,061.67 by a certain date. Mr. Mallory allowed the policy to lapse and received a 1099-R from the insurance company stating he owed income taxes on a total of $150,397.25, which is often considered “Phantom Income”. The Internal Revenue Service (IRS) stated he had taken a total of $237,897.25 in gross distributions ($133,800 in total loans and $104,097.25 in accrued interest). Because Mr. Mallory policy’s cost basis was $87,500, he was to pay income taxes on $150,397.25 ($237,897.25 – $87,500 = $150,397.25)[3].

The “Phantom Income” Mr. Mallory owed to the IRS is something that is either missed, misunderstood, or not explained when an individual is being sold a policy with a cash value component. As mentioned above, we do not necessarily have an issue with having a policy with a cash value component; the issue arises from the advisor’s lack of explanation and potential consequences to the individual based on how they utilize such policies. And it doesn’t end with taking loans to support retirement. Often these policies are sold, stating that at a certain point an individual can apply their cash value to pay for their premiums. What is happening is the individual is taking a loan to pay the policy’s premiums via the cash value thereby effectively reducing their death benefit (revisit our third point from above – if you die, the death benefit is reduced by the loan amount). If the loans from the cash value to pay the premiums completely deplete the policy’s cash value balance, the policy will lapse, potentially triggering “Phantom Income”.

“Phantom Income” is only one such item that is not often discussed when buying a policy with a cash value component. We encourage individuals to get objective advice, or to put it simply, speak to a qualified professional who is not compensated by selling a certain product. Often these individuals will explain the details and inner workings of these products, and help guide you to make an educated decision. Our goal at LBW is to transform wealth management, and one way we want to change the industry is by providing education to anyone who asks. So, if you have questions or want a second opinion, please give us a call as we are MORE than happy to give you our thoughts. Remember – when you are told you can “borrow tax-free from your policy” there is always something lurking beneath that statement. Maybe, it is the PHANTOM OF THE INCOME!



[1] e.g. Whole Life, Modified Whole life, Universal Life, Variable Universal Life

[2] https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax

[3] http://www.ustaxcourt.gov/ustcinop/opinionviewer.aspx?ID=10813

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