The estate planning landscape has changed dramatically during the past decade. The gift and estate tax exemption currently stands at $5.49 million per individual and is adjusted annually for inflation. The highest marginal income tax rate (43.4%, including the 3.8% net investment income tax) exceeds the top federal estate tax rate (40%). For these reasons, many families are shifting their estate planning strategy away from gift and estate tax reduction and towards income tax reduction.
Private Placement Life Insurance (PPLI) is fast emerging as an effective tax-planning tool for investors in hedge funds and other alternative investments. Though these investments offer higher upside potential, the downside is that, in many cases, they’re highly tax inefficient. For example, hedge funds typically generate short-term capital gains which are taxed at the same rates as ordinary income. Holding investments through a PPLI policy allows earnings to accumulate tax-free. While earnings are ultimately taxed as ordinary income upon withdrawal, investors who hold these policies for life can avoid these taxes permanently.
PPLI is a form of variable universal life insurance that offers more sophisticated investment options than traditional policies. Generally, these policies are designed to maximize cash value growth while minimizing death benefits. Although you might expect PPLI policies to be more expensive, because of the fact that they generally have much lower commission rates, all else being equal, they tend to be less expensive than traditional policies.
Like other life insurance products, a PPLI policy’s earnings aren’t currently taxed, allowing its investments to grow at an accelerated rate. During the life of the policy, you can access its cash value tax-free either by:
- Withdrawing the cash value up to your investment in the contract (generally, cumulative premiums paid, less any dividends or other nontaxable amounts received under the policy); or
- Borrowing against the policy’s cash value, though that borrowing could lead to negative tax implications if the loan isn’t repaid during your lifetime.
From an estate planning perspective, if you hold a PPLI or other life insurance policy for life, your beneficiaries will receive its cash value and death benefit income tax-free. This makes it possible to permanently eliminate income taxes on investments held in the policy.
Be aware that not just anyone can purchase a PPLI policy. Because PPLI is an unregistered securities product, you can’t invest in it unless you’re an “accredited investor” and a “qualified purchaser” as the terms are defined by the Securities and Exchange Commission (SEC). To be an accredited investor, you must have either:
- A net worth of $1 million or more, alone or together with your spouse (excluding your primary residence); or
- Income of at least $200,000 (single) or $300,000 (joint) in each of the previous two years.
Generally, to be a qualified purchaser, you must have $5 million or more in net investments.
Do Your Due Diligence
PPLI is a sophisticated insurance product that involves inherently risky investments, so it’s important to evaluate your options carefully. It’s critical to choose a reputable insurance carrier that understands the complex rules governing life insurance, and knows how to structure a product so that it qualifies as life insurance for federal tax purposes.
While you’re permitted to select investments from the insurance carrier’s menu of funds, you’re prohibited from exercising any control over an investment manager’s decisions. So be sure to research each fund’s investment philosophy and track record carefully before you invest.
If you have questions about whether or not a PPLI is right for you, contact your Untracht Early advisor. And for information on how to effectively use other tax planning vehicles, be sure to watch this month’s Next Up video.