Tax MagicTurn Every Dollar of Investment Income into Tax-Free Income

June 1, 2014

“Tax-free” als has a nice ring to it. The higher the income-tax rate the nicer the ring. The old top rate, at 35 percent, was bad enough. The current highest rate—39.6 percent—has created a flurry of activity to legally avoid the tax.

But wait, there is an additional surtax that can bite you for another 3.8 percent on passive investment income. And there can be more: Your home state may have an income tax. Some states (including Nevada and Florida) have no tax. And other states—New York at 8.82 percent, California at 9.3 percent and Hawaii (the highest) at 11 percent—have killer top rates.

		PPLI
End of Year	Taxable Investment	Cash	Death Benefit
1	$2.650	$2.665	$43.900
5	12.288	13.351	43.900
10	16.445	20.508	43.900
20	29.450	50.071	61.087
30	52.740	125.095	133.851
40	94.449	312.915	328.560

Results, in $ millions (rounded)

So, if you have a large amount of investment income your tax burden can range from a low of $42.4 percent to as high as 53.4 percent.

This gives us a worthy target to make tax-free. But how? The answer, as you will learn in this article, lies in private-placement life insurance (PPLI).

To start, let’s see how your wealth accumulation is impacted by taxable vs. tax-free. The following example (created by Lewis Schiff, an Austin, TX lawyer) will astound you.

Facts: A PPLI policy insures a 45-yr.-old male (Joe) paying $2.5 million each year in premiums for 5 yr., a total of $12.5 million. The assumed rate of return is 10 percent (net of investment-management fees), taxed as ordinary income at 40 percent, including Federal and State taxes.

Take a moment to study the results above. If Joe lives to age 75, his cash value is $125 million, vs. $52.7 million for the taxable investment; the death benefit gives him a tax-free bonus of nearly $9 million—certainly a worthy target.

The prime purpose of PPLI is to make investment profits (whether capital gains, dividend income or interest income) tax-free. Simply put, all policy investments are wrapped in a tax-free insurance envelope.

What is PPLI?

PPLI is a form of variable universal life insurance offered privately rather than through a public offering. Variable life insurance has cash value dependent on the performance of one or more investment accounts in the policy.

There are an endless amount of tax magic tricks you can do with PPLI. For example, with a private-placement variable annuity (PPVA) investment account, a wealthy client (Jim) can put after-tax dollars to work in a tax-deferred account. As long as the assets stay within the account, Jim does not recognize any income. However, if Jim withdraws any money from the account, then he recognizes taxable income. The minimum size for a PPVA is $1 million, with many ultra-affluent families putting $100+ million into these accounts. Because the asset commitment is much higher than for a retail annuity, the costs are much smaller, usually under 1 percent/yr. Those looking to defer more assets in addition to traditional retirement accounts should consider a PPVA account.

Here’s a smart to use a PPVA to endow your foundation or a public charity. Let’s say you have $100 million of wealth and you know with reasonable certainty that you will never need to touch $25 million of that wealth. So, you put $25 million in a PPVA and the money grows tax-deferred. If you need to access the money, you can do so. But if you don’t touch the money, all of it will go to a charity or foundation at your death. At current tax and life-expectancy assumptions and reasonable growth rates, three to four times more money will go to charity using your PPVA.

With a PPLI, you put after-tax dollars to work in the form of an insurance premium. There are two components to your PPLI account—a tax-deferred investment account and an insurance benefit. When you put money into a PPLI, one of two scenarios play out. In one, you never touch the money during your lifetime—the funds grow tax-free (minus the insurance charges) and pay out income-tax free at your death. In the other scenario, you decide during your life that you want to take some money out of the policy. Simply withdraw the amount you want, free of tax. If you want to access more than the policy’s cost basis (i.e. the premiums paid), you can borrow at reasonable rates from the policy—also income tax-free.

With a PPLI, you’re buying life insurance and must pass an insurance physical. Premium costs depend on your age and health.

Investment Flexibility

In either a PPVA or a PPLI, you can, with the help of the insurance company, select from a large number of hedge funds. Or, you can work with a third-party advisor. You can even switch advisors or have more than one. The insurance carrier will help guide you as to required diversification.

If you have a large investment portfolio, whether CDs, municipal bonds, hedge funds, stocks or bonds, or any of the other endless parade of investment vehicles, a PPVA or PPLI is a smart wealth-multiplying strategy. Your wealth compounds at an accelerated pace, because you won’t lose one cent to income taxes.

Thanks to Aaron Abrahms, a partner at Winged Keel Group, New York City, NY, for providing technical advice for this column. MF

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