Whole life insurance is specifically limited by the IRS from being a good investment
For many years, whole life insurance policies were incredible tax planning tools. The contracts were a great vehicle to fund substantial premiums into the policy, accumulate a large cash value of life insurance within the policy, grow tax-deferred, and ultimately be distributed using loans on a tax-free basis. (This can be a trap, as outlined below.) However, in the Technical Corrections Act of 1988, Congress limited how quickly a life insurance policy can be funded and how much additional funding can be placed into the policy. The rules create a focus on the insurance component, which is an intentional headwind against investing.
no tax-free withdrawals, only tax-free loans
There are no tax-free withdrawals from a whole life insurance policy. Rather, the policy is funded and, at a later date, loans are taken out against the policy. There are several problems with this. The first is that taxes are not owed because the payments are a loan on which interest must be paid. When a doctor borrows from that policy, interest accumulates and ultimately reduces the death benefit of the policy.
Worse yet, if there is no longer enough cash value to support premium payments, a doctor might find him- or herself unable to pay for insurance premiums late in retirement. If the doctor is unable to pay the premiums, the policy can lapse, and all of the loans that were paid over time become taxable. The dark reality of tax-free withdrawals from whole insurance policies is they become significant debts on the balance sheet of retired doctors that, despite being paid in full when the death benefit pays out, result in a significant liability at a time in life in which cash flow flexibility is incredibly limited.
Lack of transparency in costs and fees
Few people who purchase whole life insurance policies understand the conditions and circumstances of each provision. Whether it is commissions, surrender fees, administrative costs, cost of insurance over time, or a variety of other fees attributable, it is incredibly difficult to find a whole life insurance illustration that accurately lays out these expenses in a clear, easy-to-understand way. Things such as guaranteed interest rates seem like a great deal, but the expenses baked into the policy dramatically reduce the rate of return for doctors funding the policies.
Whole life returns are not guaranteed
The reality is that whole life insurance returns are set by the insurance company and the insurance company can cut the rates of return of policies. As an example, Northwestern Mutual dropped from 6% in 2011 to 4.9% in 2018, despite the prime rate increasing.1 The Guardian Life Insurance Company of America dropped its return rates from 6.85% to 5.85%.2
This means if a sales illustration projected a dividend rate higher than the current dividend rate, the policy will underperform the projection. The underperformance of policies written in the higher interest rate environments of the late 1990s are a significant issue for many of our clients who counted on the growth from whole life insurance policies as a portion of their retirement savings.
Cash value of life insurance is surrendered at death
In a whole life insurance policy, if the death benefit is $1,000,000, it does not matter if the doctor has accumulated $50,000 or $300,000 of cash value in the policy. At the death of the insured, beneficiaries will receive only $1,000,000, and any additional cash value is forfeited. This means if policies are overfunded with the intention of using loans to fund retirement expenses, all the accumulated savings are lost despite receiving a payment for the death benefit, and the total amortized cost of coverage for the death benefit received can be appreciably higher than just the premiums paid.
It is important to note that the point of this article is not to vilify whole life insurance. Rather, it is to highlight some of the often-ignored issues during the sale of a policy and to encourage a dialogue as to whether whole life insurance is an appropriate purchase or if another investment is a better use of a doctor’s resources.
References
1. NFP – Historical Whole Dividends Rates (1988-2016). https://internal.nfp.com/webfiles/public/insurance/prodexpert/Historical_Whole_Life_Dividends.pdf.
2. NFP – Historical Whole Dividends Rates (1988-2016). https://internal.nfp.com/webfiles/public/insurance/prodexpert/Historical_Whole_Life_Dividends.pdf.
Andrew Tucker, JD, Cfp, CPa, and John K. McGill, JD, MBA, CPA, provide tax and business planning for the dental profession and publish The McGill Advisory newsletter through John K. McGill & Company Inc., a member of the McGill & Hill Group LLC. It is your one-stop resource for tax and business planning, practice transitions, legal, retirement plan administration, CPA, and investment advisory services. Visit mcgillhillgroup.com or call (877) 306-9780.
