A Roth IRA Alternative for high-income earners
Written by Thomas A. Lane, Jr., ChFC®, CFP®
Updated: April 20, 2023
Roth IRAs – How they work:
- Roth IRAs are a phenomenal tax-planning/wealth accumulation tool, with “a catch“
- Contributions are made on an after-tax basis
- All appreciation in the account is tax-deferred
- Unlike Traditional IRAs – distributions from a Roth are “TAX-FREE”
- No Required Minimum Distributions (RMDs) for Roth IRA owners
- Effectively paying tax “on the seed” and getting “the harvest” for free!
Roth Limitations/Restrictions:
Annual Income Restriction – if married, Modified Adjusted Gross Income (MAGI) cannot exceed $228,000; if single, MAGI cannot exceed $153,000[1]
Contributions limits – $6,500 per individual of earned income, including a non-working spouse, plus a $1,000 catch-up for taxpayers aged 50 and up
The Catch:
- Those that have the resources to fund a Roth IRA are often limited by the income restriction.
- Those who are not restricted by the income limitations are often unable to contribute to a Roth due to limited resources and an inability to save.
- What options do high-income earners have?
Roth Alternative – “Retirement Life/Max-Funded IUL”:
Summary: The major hurdle clients must clear to benefit from this strategy is to dispel the longstanding notion that life insurance cannot be used to efficiently accumulate value. This strategy uses or “borrows” the life insurance chassis as the funding mechanism for several reasons, most important are the tax-favored benefits offered by cash value life insurance, including tax-deferred accumulation, tax-free death benefit, and tax-fee policy loans. Furthermore, using the Max-Funded IUL strategy as a Roth Alternative, high income earners are not faced with the income restrictions or funding limitations that make funding a Roth IRA impossible, barring a Roth Conversion, which involves converting Traditional IRA assets to Roth IRAs. Taxes are due on the converted amount in the year the conversion takes place.
Historically, accumulating assets inside a life insurance policy has been difficult due to the manner in which cash value accumulates, which has been directly linked to the issuing company’s general assets and thus, conservative investments that are inherent in the insurance industry[2]. Further restricting competitive growth inside a life insurance policy are the mortality and administrative costs associated with the “traditional” use of cash value life insurance. Most life insurance is purchased with the maximum death benefit being the primary objective, which results in higher mortality costs. Most insurance buyers willingly and regularly trade off cash value accumulation for death benefit, and rightfully so, if death benefit is the driving force behind the decision to purchase life insurance in the first place. Term life insurance is a perfect example of the trade-off between sacrificing cash value accumulation – there is none – for death benefit!
Determining Premium Levels: It is important to note how premiums are determined and which entities govern how much or how little premium can be paid into a life insurance policy. The life insurance companies themselves determine the minimum premium that must be paid into a life insurance policy to maintain a specific death benefit at a certain age and health status, a perfect example being a ten-year level term policy that provides maximum death benefit for the least amount of cost.
The IRS governs the maximum amount one can pay into a life insurance policy. The Federal Tax Code determines the maximum amount of premium that can be paid into a life insurance policy under IRC Section 7702. This tax code provides various testing to determine if premiums exceed the maximum amount that can be paid into a life insurance policy. The intent of the Max Funded IUL strategy is to fund a policy up to the “maximum guideline premiums” outlined in the tax code to take full advantage of the numerous tax benefits available in cash value life insurance. Therefore, the goal with this strategy is to allocate as much premium as possible and secure the least amount of coverage allowable, without violating the Federal Guidelines.
The challenge: The goal of this strategy is to maximize the cash value accumulation by minimizing the internal expenses that historically restrict the growth inside cash value life insurance. The greatest expense of which is the mortality expense, essentially the “term costs”. Understanding how mortality expenses are assessed is critical to understanding the strategy:
- In a universal life insurance policy, the company assesses mortality costs by determining the amount at-risk to the company, which is the difference between the face amount and accumulated value. Simply put, if the face amount of the policy is $1,000,000 and the cash value is $220,000, the amount “at risk” to the insurance company is $780,000. A company will assess mortality costs only on the $780,000 and not the full $1,000,000 in this scenario.
- The goal is to minimize the at-risk amount to the insurance company by structuring a contract/policy that will emphasize cash value accumulation with little or no regard to the death benefit. It is important to emphasize, although this strategy will provide a tax-free benefit to the chosen beneficiary, the amount of death benefit provided should not be a relevant factor when considering this strategy.
Managing Costs: In a maximum funded indexed universal life (IUL) contract, the mortality costs will represent, as a percentage, a small fraction of the overall value inside the policy. The policy gains value over time as 1) additional premiums are contributed and 2) as interest is credited to the contract. Over time, the mortality costs become “diluted” as they represent a smaller fraction of the overall policy value each passing year.
- For example: If the accumulation value of a policy is $500,000 and the death benefit is $1,250,000, the amount at risk to the insurance company would be $750,000. If the annual mortality costs were $3,500, the mortality costs as a percentage of the total cash value would be .70% or 70 bps. That is less than the operating expense of the majority of actively managed equity mutual funds.
Tax Benefits: The tax benefits offered by life insurance are significant and include the following:
- Tax-Deferred Growth – The cash value of a life insurance policy is not subject to current taxation as it accumulates.
- Tax-Free Death Benefit – The death benefit is income tax-free to the beneficiaries, though if the policy is owned by the insured it will be included in his/her taxable estate and may be subject to estate tax[3].
- Tax-Free Withdrawals – If a policy meets IRC premium guidelines and is not considered a MEC (Modified Endowment Contract), withdrawals from the policy are not taxed until the total withdrawals exceed the premiums paid, or basis.
- Tax-Free Policy Loans – It is possible to take distributions from a policy that exceeds basis if taken as policy loans. As long as the policy does not lapse, and policy loans are paid back from the death benefit, all loans received during lifetime are tax-free. Policy loans can be an extremely effective method of taking distributions from a life insurance policy.
Earnings/Interest Credits: The manner in which interest or earnings are credited to an indexed universal life insurance contract is what distinguishes this strategy from others that have been used in the past, like using traditional universal life or whole life policies whose crediting methods are directly linked to the general assets of the life insurance company. Subsequently, the earnings in traditional policies are limited to the low rates of return offered by investment grade fixed income investments, the most widely held asset by most highly rated insurance companies.
The interest credited to an IUL contract is directly linked to an underlying index, or blended index. For simplification, assume that the linked index is the well-known Standard and Poor 500, or S&P 500, sans dividends. This index, including dividends, historically has averaged roughly 11.64%[4], much greater than fixed income investments.
It is important to note, that a direct investment in an index is not made by the policy owner, the insurance company simply credits interest that is linked to a corresponding index selected by the policy owner annually from a list of available crediting methods, i.e., indices.
Most insurance companies will “cap” the interest credit for each contract year. Current caps vary from company to company and range from 8% to 16% to uncapped strategies[5]. The caps will adjust upward or downward, depending on two factors, 1) current interest rates and 2) market volatility, the second of which directly impacts the price of the underlying options used to “fund” the contracts.
- For example: Assume that the policy earnings are “linked” to the S&P 500 and that the index return for the policy year was 9%. If the policy value was $500,000, the earnings credited to the contract for that year would be $45,000.
- Using the morality example given previously, if the mortality costs were $3,500, the net gain for the contract year would be $41,500 ($45,000-$3,500), or 8.3%.
Protection against Loss of Principal: It is important to emphasize that if the underlying index return for the corresponding time frame is negative, then no interest is credited to the contract value for that contract year. Therefore, other than a reduction from mortality and other expenses, the principal is not impacted in a year when the index return is negative. The reason this is possible is as follows:
- The life insurance company takes the interest earned on the general assets used to back the life insurance values and purchases “call options” on the various indices. Understanding how options work, if the index return is positive, the option is “in the money” and the earnings from the option are allocated proportionately to each contract. If the index return is negative for the policy year, the option expires with no value and no interest credits are applied for that contract year. This is a very simple explanation of a more complex investment strategy used by the insurance companies to fund these IUL contracts.
In this writer’s opinion, this makes Indexed Universal Life (IUL) the product of choice when utilizing this approach as opposed to variable universal life, which can lose value when the market suffers a down year.
Policy Loans – Interest Credits: The tax-free policy loans are the key to making this concept work. It is extremely important to select a company that offers a “fixed rate” loan that is written into the contract. It is also important to select a company that offers “participating” loans. A participating loan will credit the loaned, or borrowed amount, with the same interest credit as the remaining cash value receives. We cannot emphasize the magnitude of selecting a company whose products offer both fixed interest rates and participating policy loans.
- For example: If the total cash value is $500,000 and the loan amount is $300,000, the total interest credited in a year when the index return is 9%, assuming a 5% fixed interest rate, would be as follows:
- Cash Value Portion – $500,000 x 9% = $45,000
- Loaned Amount – $300,000 X (9% – 5%) = $12,000
- Total interest credit: $57,000
- If the index was negative for the year, no interest would be credited, and $15,000 of loan interest would be debited against the policy value
How it works:
- Determine the amount of funds you want to allocate annually to the strategy and for how long you want to contribute
- Review various options offered by several top carriers
- Given age and health status, purchase the minimum amount of death benefit allowed using the IRC Premium Guidelines
- The plan is funded with “after-tax” dollars, like a Roth IRA, as rapidly as possible without creating a MEC; typically, five to ten years.
- The plan assets accumulate on a tax-deferred basis
- The primary costs associated with the plan are the mortality costs, which are “diluted” as a percentage as policy values grow
- The plan assets are tied to a single or blended index and may be capped, or uncapped depending on the strategy selected, which can change annually
- Plan values are 100% protected from market decline
- Distributions taken as policy loans from the plan are “tax-free”, can be taken at any time, and used for any purpose, i.e., college funding, major purchases, retirement, etc.
- There are no tax penalties if distributions are taken prior to age 59 ½, unlike most retirement plans, as this strategy is not subject to the IRS guidelines governing qualified plans (401(k), 403(b),) and IRAs
- The plan is self-completing in the event of death
[1] As per the 2023 IRS Guidelines
[2] We refer to traditional whole life and universal life insurance policies. Variable life policies can earn higher rates of return, but are also subject to market risk. We are not referring to variable life insurance in this article.
[3] If the policy owner is interested in the tax-free income offered by this strategy, it may be difficult but not impossible to exclude the proceeds from the estate. Please consult a tax attorney
[4] The average rate of return of the S&P 500 from 1928 to 2022, according to research completed by NYU, was 11.51% – https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datacurrent.html
[5] Certain strategies offered by investment firms to insurance companies can be uncapped