What is Life Insurance Premium Financing?
Life insurance premium financing is a strategy whereby a qualified borrower accesses third-party financing to pay for large life insurance premiums. The insurance companies’ structure-specific insurance products for these financed plans to minimize outside collateral and maximize returns. This allows individuals and businesses to leverage current assets, maximizing returns via a predetermined cash flow.
Who needs Life Insurance Premium Financing?
Premium financing has been a strategy that high-net-worth individuals use to help pay their life insurance premiums when they have a large policy and premium need, but prefer not to liquidate assets or investment that reduce cash flow for the premiums. High-net-worth individuals often need to have life insurance coverage with death benefits of more than 10 million dollars to address their business succession, family inheritance, or estate tax planning needs. Premium financing strategy allows those people to pay the premiums by borrowing money from a third-party lender, instead of using cash or liquidating investment assets.
A premium financing strategy is for those who have a net worth of 5 million dollars or more with significant collateral to obtain loans, have needs for life insurance protection, have illiquid or appreciating assets. It is an attractive option to anyone who needs a substantial amount of insurance for estate-planning, wealth accumulation, liquidity at death, asset protection, or business purposes.
Which life insurance policy is the best choice for Premium Financing?
There are a variety of life insurance policies available for premium financing. Term life insurance is not suitable because of its inherent limitations factor. Permanent policies are a better choice because they ensure tax-free benefits to your heirs. However, not all permanent policies are good. Whole life policies tend to restrict what you can do with the policies. Variable life insurance tends to come with higher risk. Therefore, an indexed universal life insurance policy is the best choice for premium financing when we’re comparing policies. An IUL policy contains both a death benefit and a cash value accumulation portion. The main reason to choose an IUL policy is because it allows you greater control. The cash value accumulation portion permits you to allocate the funds to a fixed account or an equity index such as the S&P 500 or the Nasdaq 100.
What do you need to consider before implementing Life Insurance Premium Financing?
Life insurance premium financing could bring many benefits to the insurer, but there are some significant things that need to be considered before insuring.
- The higher the amount of your life insurance policy, the more costly the premiums on it.
- Three areas of risk for insurance premium financing are qualification risk, interest rate risk, and policy earnings risk.
- One concern would be that the cash value of the policy may not increase as fast as the interest rate.
What are the risks of Life Insurance Premium Financing?
There are three main risks that need to be considered before making any decision.
- Interest Rate Risk: Interest rates are low now, but if they rise it could spell trouble. Most of the time a premium finance loan will have a variable interest rate. However, when interest rates rise, it could really eat into the advantages you were trying to accomplish in the first place.
- Qualification Risk: Lenders typically require borrowers to re-qualify each time the loan is renewed, at which time the loan’s collateral is re-evaluated (collateral might include real estate, stocks, and other assets and investments). If the value of the collateral has fallen below a certain threshold, the insured may have to provide additional collateral against the loan.
- Policy Earnings Risk: If the policy’s cash surrender value underperforms, the loan balance could exceed the value of the collateral, in which case the insured would be forced to provide more collateral to avoid default.
What are the tax regulations of Life Insurance Premium Financing?
For most of the time, tax implications of borrowing to finance a life insurance premium is the same with borrowing for other purposes. Some exceptions are listed below:
Deductibility of Loan Interest
Individual taxpayers are not eligible for deduction for interest paid on amounts borrowed for the payment of life insurance premiums, as it is deemed to be personal interest.
In cases involving a corporate or business-owned life insurance policy, the corporation or business may be able to deduct the interest in certain situations.
An Irrevocable Life Insurance Trust (ILIT) is created to own and control a permanent life insurance policy while the insured is alive, as well as to manage and distribute the proceeds that are paid out upon the insured’s death. An ILIT has several parties — the grantor, trustees, and beneficiaries. The grantor typically creates and funds the ILIT. Gifts or transfers made to the ILIT are permanent, and the grantor is giving up control to the trustee. The trustee manages the ILIT, and the beneficiaries receive distributions.
Avoid Gift Tax
A properly drafted ILIT avoids gift tax consequences since contributions by the grantor are considered gifts to the beneficiaries. To avoid gift taxes it is crucial that the trustee, using a Crummey letter, notify the beneficiaries of the trust of their right to withdraw a share of the contributions for a 30-day period. After 30 days, the trustee can then use the contributions to pay the insurance policy premium. The Crummey letter qualifies the transfer for the annual gift tax exclusion by making the gift a present rather than future interest, thus avoiding the need in most cases to file a gift tax return.
If you are the owner and insured, then the death benefit of a life insurance policy will be included in your gross estate. However, when life insurance is owned by an ILIT, the proceeds from the death benefit are not part of the insured’s gross estate and thus not subject to state and federal estate taxation. If properly drafted, the ILIT can, however, provide liquidity to help pay estate taxes, as well as other debts and expenses, by purchasing assets from the grantor’s estate or through a loan.