A Silver Lining to the Cloud of Higher Tax Rates?

Grey days ahead in 2011?

Why grey?  Well, I can't imagine that anyone is really excited about paying more taxes.  There may be some who consider it a necessary evil, but I am going to steer clear of that discussion.  So where is the silver lining?  Tax equivalent rate of return.  Where can we maximize it?  Life Insurance.

We all understand it and can all calculate it, but some of our clients may have a bit of a problem wrapping their heads around it without a certain level of sophistication.  It's up to us to show them the way, and the best way I know is with an example.  Here's the situation:

• Male age 65, Preferred risk for Life Insurance at policy issue 20 years ago
• $100K in Surrender Value in the policy with $200K face amount
• Male age 65
• $100K in taxable account at age 65

First, consider the impact of the projected increased top rate of 39.6% in 2011 versus 35% in 2010 on distributions from the taxable account:

• $5000 Distribution
• Taxes in 2010 = $5000 X .35 = $1750, net distribution = $3250
• Taxes in 2011 = $5000 X .396 = $1980, net distribution = $3020

For those of you keeping track at home, that is a decrease in net spendable of 7.08% ($230/$3250).  Ouch.  Now let's take that same amount from a life insurance contract:

• $5000 Distribution, withdrawals to basis, then loans
• Taxes in 2010 = $5000 X .00 = $0, net distribution = $5000
• Taxes in 2011 = $5000 X .00 = $0, net distribution = $5000

No change, but what is the increase in net spendable income?

• Versus 2010 = 53.85%
• Versus 2011 = 65.56%

Sounds great right?  But how did we get here?  What did it take to accumulate that much cash in the life insurance contract versus a taxable account?  Great questions.  Obviously, we have to pay more.  We're getting more value than we would from a taxable investment account.  How so?  Consider:

• Life Insurance Death Benefits
• Tax deferred accumulation
• Tax deferred distributions (can be tax free if structured properly, but be careful tossing that term around!)

How much more do we have to pay?  About $830 more per year for 20 years if we use the same gross rate of return (6%) and long term capital gains tax treatment at 15%.  I'd do that deal all day long, every day.  To bring this conversation full circle, that $5000 is equivalent to a taxable distribution of just about $8300.  Who here thinks they can do that year in and year out and not invade the principal in a $100K account? 

Skeptical?  Check out the life insurance illustration and spreadsheet of all the calculations for the math.