What is overloan protection and why do your clients need it?
As a financial professional, we are tasked with educating and protecting our clients from a vast array of different risks to their collective financial futures. We have many conversations about market risk, inflation hedges, longevity concerns, interest rate risks, and liquidity concerns. One risk that clients sometimes look past is the impact of potential rising tax rates in the future.
While you may not hear many clients remark about the historically low income tax rate environment, the facts of course demonstrate that reality. Many are surprised to learn that for 2 full decades known for their historically thriving economy (the 1940s and 1950s), the top federal income tax bracket was between 80-94%, compared to 37% today. If those rates even approach the average rate of roughly 59% since 1913, this of course would have major implications for the vast number of Americans who focus all or most of their retirement in tax deferred accounts like 401(k)s and IRAs.
One solution you have likely presented to help mitigate this tax risk is utilizing the cash value of life insurance through tax-free policy loans. Whole life in particular offers stability through guaranteed returns (and non-guaranteed dividends). But are there any inherent tax risks in this solution?
Consider this hypothetical scenario:
Your client retires at age 65, having accumulated $1 million in cash value from a whole life plan that you helped implement. After a discussion of income needs and realistic expectations of family history, you agree to take a level amount of withdrawals up to cost basis and policy loans, and calculate the maximum possible to draw out for the next 15 years. So what happens, should the client reach age 80 in impeccable health, having loaned out essentially all of the cash value in the contract?
You will have a significant problem on your hands. If the remaining cash value cannot support the interest due that year, the contract will lapse, and every single dollar loaned over cost basis will be recognized as ordinary income received in that year (even though the money is long since spent). In this example, that could equate to a tax bill in the hundreds of thousands of dollars. The alternative is that the client would need to begin making out of pocket interest payments to keep the policy afloat so long as they live. That is one less income stream, and a brand new bill in late stages of retirement potentially totaling tens of thousands of dollars or more each year.
As of this date, PennMutual is the only carrier with a dividend paying whole life product that offers a potential solution. The Overloan Protection Benefit Rider, which is available on all non-MEC whole life contracts for no added cost, addresses this risk. This rider has the ability to prevent the policy from lapsing. If an outstanding loan exceeds 99 percent of the cash value, the rider keeps the policy inforce as a reduced paid-up policy with an outstanding loan. To exercise the rider, the insured must be at least 75 years old and the policy must be in effect for at least 15 years.
The ability to keep a tax-advantaged income strategy in retirement free from additional tax risk is no small consideration in your clients’ financial planning. To learn more, please reach out to the Advanced Sales team at Empire Wealth Strategies.