Cash Value in Life Insurance

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In the first installment of my life insurance series, I outlined the primary differences between term, whole, and universal life insurance. Generally, whole and universal life build cash value and term does not. While the primary purpose of life insurance is to provide money to replace income in the event of premature death, it is the existence of cash value that can provide unique planning opportunities to the policy owner. In this piece, I will provide a general overview of how cash value and policy loans against cash value are treated from a tax perspective. In order to get an idea of how cash value insurance can work for you, it’s helpful to familiarize yourself with some general terms and rules associated with it. This overview should not be interpreted or construed as tax advice or specific advice regarding how to best use you own life insurance.

 

Tax Treatment of Cash Values (Non-MEC)

Cash values that accumulate in a life insurance policy grow tax deferred. Additionally, cash withdrawals are treated on a first-in, first-out (FIFO) basis. This means that withdrawals up to your cost basis are tax-free. Your cost basis is the total amount of premiums you paid minus any dividends and any tax-free withdrawals that were made. Amounts in excess of cost basis are taxed as income. This tax treatment allows for opportunities to use the cash accumulations for various financial planning strategies. For example, if you have $200K accumulated in the cash value account of your policy, $100K of which is cost basis, you may be able to take out (depending on your policy) $100K before you use up your basis.  This is tax-free money that can be used to supplement retirement income or contribute to tuition costs.

 

Policy Loans (Non-MEC)

Policy loans use the cash value as collateral for the borrowed amount, and are usually not taxable. This is the case even if you borrow more than the premiums you have paid in. These types of loans are not taxed as long as the policy is in force and are a popular way of leveraging accumulated cash. Interest on policy loans is not tax deductible.

 

Modified Endowment Contract (MEC)

In order to get the favorable treatment described above the policy must qualify as a non – MEC. Prior to the Deficit Reduction Act of 1984 (DEFRA) owners of cash value life insurance could put large amounts of cash in their policies and shelter the growth from taxation. DEFRA established for the first time a legal definition of life insurance. If a policy does not conform to this definition, it is deemed a Modified Endowment Contract (MEC) and technically not a life insurance policy. MEC rules placed limits on the borrowing or withdrawal of cash from policies on a tax-free basis. Also, if the premium payments made into the cash value of the policy exceed certain limits during the first seven years of the policy, it will be reclassified as a MEC. Under MEC rules, policy loans are taxable, and withdrawals may be taxed or even penalized. MEC rules apply to contracts issued after June of 1988 (as there was some grandfathering of existing contracts). These special tax rules are very complex and you should consult with your advisor to best understand how these rules may or may not apply to you.

 

Review Your Policy

The unique tax treatment and relative flexibility of cash value life insurance allow, within limits, for opportunities to use funds for a variety of financial planning objectives. Using accumulated cash to supplement retirement income or fund educational expenses are examples of common strategies. The key is to understand your policy and the details of how it can work for you. The first step is to locate your policy and most recent statement, and have these reviewed by someone who can explain the details and nuances.

Our Next Installment: The role of life insurance as a way of providing protection, liquidity, and leverage for estate planning strategies.

 

Dwight Davenport

Principal, Vodia Capital, LLC

Demystifying Life Insurance

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Life insurance can provide exponential financial leverage to families and individuals in a variety of circumstances and planning scenarios. It can be used to simply replace income in the event of the death of an income earner, to provide cash to an estate for tax settlement, to fund business succession or continuation plans. This précis is the first in a short series that will attempt to demystify the life insurance world and shed light on some powerful strategies.

Very often clients ask us to review, explain, and make recommendations regarding their life insurance. Our clients’ questions run the gamut from how much should be purchased to how it might be used in complicated estate planning scenarios. The place to start is the three basic types of life insurance:

  • Term
  • Universal Life
  • Whole Life

Term insurance operates as the name implies. One pays an annual premium over the course of some term of years to be awarded a certain amount upon the death of the insured. One-year renewable, five, ten and, twenty-year terms are pretty standard term insurance options. Term insurance does not build cash value.

Universal Life (UL) and Variable Universal Life (VUL) are variants of a type of insurance known collectively as “universal life” and is a bit more complicated.

UL has term insurance and cash value features that are bundled together under one policy. It is considered to be a “permanent” policy because excess premiums are paid and credited to the cash value. In a typical UL policy the cash value is credited with a fixed interest rate for a set period (usually one year). UL policies can be flexible in terms of the amount in excess premiums that can be paid into the policy. These excess amounts are subject to limits set by the IRS.

VUL is very similar to UL except the cash value account consists of variable sub-accounts. These “sub-accounts” usually shadow a publicly traded mutual fund. The term “variable” generally refers to the fact that the underlying investment will fluctuate in value. Almost any type of publicly traded mutual fund can be held in a VUL. The idea is that the cash values can build more quickly because they are being invested.

Because cash values grow tax deferred and withdrawals (if they are allowed) may receive favorable tax treatment both ULs and VULs can be used creatively in a variety of financial planning scenarios. Using universal life to help pay educational expenses or provide income in retirement are examples. I will explain more on insurance strategies based on ULs and VULs in my next installment of this series.

The third category is Whole Life insurance. Whole Life is considered to be a true permanent policy as it provides death benefit coverage for the “whole” life of the insured. There are basically two types of whole life policies: “participating” and “non-participating”.

In a non-participating contract all policy values are established at issuance. This means that death benefit, cash values, and premiums are pre-set.

In a participating contract the policy owner shares in any excess profits the company makes or the company may refund any overages in premium and will return these back to the policy. These are called dividends and there are many ways in which they can be used. Choosing the correct dividend option is important because it can affect the long-term performance of the policy.

Life insurance and its uses is a very broad topic. There are many important factors that need to be accounted for when considering using life insurance as a financial strategy. These include the financial strength of the underwriting company, the performance of the underlying assets, the underwriters’ claims experience, and fees to name a few. This brief introduction is designed to help explain some basic insurance types and terminology. In future installments of this series I will dig deeper into some very powerful and interesting strategies and explore how, with careful planning, life insurance can be used to build integral advantages into a family’s financial circumstances. I am always available for questions and/or discussion in the meantime.

 

Dwight Davenport

Principal, Vodia Capital, LLC

Using Stock Options in your Portfolio

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What is an Option?

Options are very complicated financial instruments that can be used in a portfolio in many different ways. Options are not for everyone, but when used by an educated investor they can actually reduce risk in your portfolio. Before using options you must understand how they work, what the risks are, and the different strategies that can be used.

An option is a derivative financial instrument that establishes a contract between two parties concerning the buying or selling of an asset at a certain price during a specified time frame. During this time frame, the buyer of the option has the right, but not the obligation, to buy or sell the asset, while the seller has the obligation to fulfill the transaction if requested by the buyer. The price of an option is derived from the value of the underlying asset (most commonly a stock) plus a premium.   Simply put, it is a contract that allows you to buy or sell a stock at a predetermined price within a set time frame.

Option Characteristics

  • Type of Option:

o   Call Option – conveys the right to buy the stock

o   Put Option – conveys the right to sell the stock

  • Strike Price – also called the exercise price, is the specified price the stock may be bought or sold
  • Expiration Date – is the specified time frame or life of the contract
  • Each option contract represents 100 shares of the stock (leverage)
  • Amount paid for option is called the premium

Call Options

 

Buying a Call Option (Bullish)

Payoffs and profits from a long call option

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An investor will typically buy a call option when they believe that the price of the stock will go above the call’s strike price, before the call expires. The investor pays a premium for the right to purchase the stock at the strike price. Typically, if the price of the underlying stock has surpassed the strike price, the buyer pays the strike price to purchase the underlying stock, and then sells the stock and pockets the profit. Of course, the investor can also hold onto the underlying stock, if he or she feels it will continue to climb even higher.

Example 1

One way to think of this in everyday life is by relating it to a house you would like to buy in a certain neighborhood.  Today a house that you like is on the market for $200,000 and you don’t know if it is a good time to buy because you’re worried that home prices may continue to go down.  At the same time, you love the house but would hate to pay more than $200,000 if prices go up. Instead of buying it today, you and the seller agree that for a $5,000 fee he will sell you the house in three months for $200,000.  The seller is now obligated to sell you the house at $200,000 and you have the right to buy the house in three months for $200,000.

Scenario 1

After three months the housing market declines and the average house in the neighborhood is now $150,000.  You decide not to buy the house since you can look around and find one at a cheaper price.  You only lose the $5,000 fee you paid the seller. If you had bought the house outright, you would have lost $50,000.

Scenario 2

After three months the housing market improves and the average price in the neighborhood is now $250,000.  You decide to buy the house for $200,000 because if you didn’t you would have to pay $250,000 to buy another house in the neighborhood. Your total cost is $205,000 ($200,000 plus the $5,000 you paid for the option).  Your gain on the house would be $45,000 ($250,000 minus $205,000). If you had bought the house outright, you would have gained $50,000, but you only had to risk $5,000 of your money, rather than $200,000.

Example 2

Now that I’ve walked you through the housing example I want to put it back into stock terms. Let’s say you are interested in a stock and after all your hard work researching it you conclude that it will increase in value over the next couple of months, but you are concerned that there is still a reasonable chance the stock will go down.  There are two ways you can act on your bullish sentiment.

Buy the Stock

One way to do this is to purchase 100 shares of stock at $20 for a cost of $2,000. If the stock rises from $20 to $25 you would have a $500 gain or a 25% increase in value.  If the stock goes down to $15 you would have a $500 loss or a 25% decrease in value.

Buy a Call Option

An alternate way to do this is to control 100 shares of stock by purchasing an option with a strike price of $20 at a premium of $2 per share for a cost of $200 (1 contract x 100 shares x $2 premium = $200). If the stock price at expiration is $25 the option premium would rise from $2 to $5, the original cost was $200 and it is now worth $500. You have a $300 profit, but a 150% return.  If the price of the stock were below $20 you would lose all of your $200 or 100% of your investment.

Don’t get too caught up on the calculations here, the key point in using call options is that it limits your risk by reducing the amount of capital needed, but because of the leverage, it leaves open the potential for higher gains.

In my next posts I will talk about using covered calls to generate income in a portfolio and buying puts to protect your portfolio from volatile downward movements.

Marcus Green

Investing in Bonds? Do you know how they work?

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Over the past two years we have seen a significant rally in the bond market due to the Federal Reserve’s decision to keep interest rates low.  This run up in bond prices raises questions surrounding profit taking and tax management.  In this post I will walk you through an example of how bonds work.  In next week’s post, we will explore how bonds impact your taxes and what you can do to maximize your profits.

Advanced Yacht Builders

Advanced Yacht Builders needs to borrow money to buy supplies.  They would like to borrow $1,000 from you at 5% interest per year for the next 10 years.  You decide that this is a good investment and you loan them $1,000 by buying their bonds.  You will receive 5%, or $50, each year for the next ten years and at the end of the ten years Advanced Yacht will give you your original $1,000 back.

Bond

 

During this ten-year loan, the price of the bond goes up and down and you are able to sell it to someone else if you’d like.  This is how bonds are similar to stocks.  They can be bought or sold at any time and are different from U.S. savings bonds or bank CDs that only pay interest and never change in value.  The price that you are able to sell the bond to someone else is determined by its yield.

By lending $1,000 dollars at 5% interest, you are receiving a yield of 5%.  Calculating the yield of a bond can get a little tricky because there are three main things to consider: bond price, interest and the amount of time the money is borrowed.  I will not get into that calculation here, but the most important things to remember are:

  • The price of a bond is determined by its yield
  • When interest rates go up, the price of a bond goes down
  • When interest rates go down, the price of a bond goes up

Scenario 1:  Interest Rates Drop

Now lets say you’re a year into lending to Advanced Yacht and all of a sudden interest rates drop and they can borrow money at 1% interest instead of 5% interest.  After breaking out a financial calculator, you would find that the price of this bond would go from $1,000 to $1,340 because the yield of this bond went down, causing the price of the bond to go up (When interest rates go down, the price of the bond goes up).  You would still receive 5% interest AND have a gain of 34% in the price of the bond.

Scenario 2:  Interest Rates Rise

Alternatively, if interest rates rose to 9%, the price of the bond would go from having a price of $1,000 to having a price of $760.  Again, as interest rates increase, the price of the bond decreases.  You would still receive 5% interest, but if you needed to free up cash, you would have to sell the bond at a -24% loss.

The price of the bond decreases because investors do not want to buy the bond that you’re holding, which is only paying 5% interest, when they can buy a new bond from Advanced Yacht that is paying 9% interest.

Crane Paper Company in Dalton produces the pap...

Next Steps

The math to calculate the yield isn’t important here.  What is important is the fact that in the scenario where interest rates dropped from 5% to 1%, the price of the bond gained 34% and that requires your attention.  Your options are to:

  • Do nothing and collect your 5% interest, but watch the 34% gain decline over time because at the end of the ten years you will only be paid back the original $1,000 that you lent
  • Sell the bond that you purchased for $1,000 to someone else for $1,340 and lock in a 34% gain, but forfeit the future 5% interest payments

In the next post, we will answer the question of how taxes are impacted in either decision and which decision is right for you.

Protect Your Portfolio with Leverage

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Leverage is often used to increase returns, but when used properly, leverage can add protection to your portfolio.  Click below to view our Prezi presentation.

Vodia Capital: Protect Your Portfolio with Leverage on Prezi