Using a VUL Policy in Place of a Roth IRA or Section 529 Plan
This article compares VUL insurance as an alternative to Roth IRAs and Section 529 Plans for retirement and college savings.
How does a variable universal life (VUL) insurance policy stack up as an alternative to a Roth IRA (for retirement planning) or a Section 529 Plan (for college tuition planning)? Using a VUL policy in lieu of a Roth IRA or a Section 529 Plan will probably not make sense if funding for retirement or college is the only objective. However, a VUL policy may make great sense where funding for retirement, college, or both, is desirable and there is also a need for life insurance. This article will explore the advantages and disadvantages of a VUL policy compared to Roth IRAs and Section 529 Plans.
VUL insurance is permanent insurance that provides a death benefit with the ability to build cash value. With VUL, the policy owner chooses which professionally-managed funds to invest the premiums (net of the cost of insurance and policy/administrative fees). These funds also charge administrative fees.
The policy is called “variable” because its account values will vary according to the performance of the funds chosen. It is called “universal” because the policy owner can set the premium amount and payment schedule – provided they are sufficient to support the death benefit and sustain the policy. A VUL policy can cover a single life or joint lives (i.e., a survivorship policy). A VUL policy is an ideal product for someone who needs death benefit protection (i.e., to replace income, to provide liquidity to pay estate taxes, or simply to create an estate) and is also looking to supplement retirement income or to save for educational expenses.
Assuming the VUL policy is not a Modified Endowment Contract (i.e., a policy that fails to meet the tests of IRC Section 7702A, which are designed to prevent the over-funding of policies), loans are free from current income taxation and withdrawals are income taxed only to the extent that they exceed the owner’s basis in the policy. But, for policies issued after 1984, a withdrawal taken within 15 years of policy issuance that reduces policy benefits is subject to income tax under IRC Section 7702(f)(7)(B). After 15 years, there is no immediate income tax. The 15-year rule does not apply to policy loans.
Thus, similar to a Roth IRA or a Section 529 plan, the account values in a VUL policy may be accessed without income taxes. However, policy loans and withdrawals may impact investment performance, death benefits, no-lapse guarantees and the tax impact upon the lapse of a policy. Moreover, unlike non-variable policies, the insurance company does not guarantee the account values of a VUL insurance policy. Since the policy values may vary either upward or downward based on the performance of the investment funds selected, a VUL policy presents a risk to the death benefit.
Both Roth IRAs and VUL policies offer the owner a choice of investment options and, for both products, the contributions/premiums are not tax deductible. With a Roth IRA, the interest or earnings on the account values are income tax free, while the interest or earnings with a VUL policy are income tax deferred. Withdrawals from Roth IRAs are income tax free if the account owner is at least age 59 ½ or older. As discussed above, with a VUL policy, withdrawals up to basis are not taxable; and policy loans are not taxable, provided the policy remains in force until the insured dies. With both products, death benefits are income tax free to the beneficiaries, provided the Roth IRA has been open for at least five years.
The biggest advantage of a VUL policy over a Roth IRA is with respect to eligibility and contribution limits. For 2008, the maximum contribution to a Roth IRA is $5,000 ($6,000 for persons over age 50) or 100% of earned income, whichever is less. Moreover, no contribution can be made for those persons earning above $116,000 (single) or $169,000 (joint). In comparison, the eligibility for a VUL policy is based solely on the insured’s age, health and net worth.
Following are the tax advantages of a Section 529 College Savings Plan:
While these tax advantages are all great reasons to use Section 529 Plans, parents must keep in mind that, if the beneficiary (or successor beneficiary) does not use the Section 529 Plan distributions for qualified higher education expenses, then the distributions are federally taxed to the distributee under the annuity rules of IRC Section 72, with the earnings component taxed at ordinary rates, regardless of whatever portion is attributable to capital gains, and with the earnings component surcharged a 10% federal penalty.
In contrast, by heavily funding a VUL policy and being careful not to go over the MEC limits, the following advantages over a Section 529 Plan are achieved:
There is another potential pitfall with Section 529 Plans. Some Section 529 Plans invest in a pre-set, unchangeable asset allocation model which becomes almost exclusively bonds as the beneficiary ages. Given the past year, that may be a good thing but, based on historical returns, this generally means less total money available due to lower rates of returns.
A useful way to think about VUL is that it’s like buying a pure term policy and investing in a mutual fund at the same time. However, unlike the usual mutual funds that may pass on capital gains and ordinary income annually, the investments in a VUL will never be taxed if the policy remains in force. Although, if the policyholder chooses to borrow against the death benefit, care must be taken to closely monitor the policy to assure that the account values (plus any continuing payments) are enough to keep the policy in force. Otherwise, the previously tax-free loans become taxable income. But, assuming the account values in the policy are sufficient to keep the policy in force while allowing for withdrawals (to basis) and loans, a VUL policy can provide the policy owner with the best of both worlds: a death benefit (for estate planning purposes) and income tax-free access to account values for retirement needs, college expenses, or both.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.
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ABOUT THE AUTHOR
Julius Giarmarco, J.D., LL.M, is an estate planning attorney and chairs the Trusts and Estates Practice Group of Giarmarco, Mullins & Horton, P.C., in Troy, Michigan. For more articles on estate and business succession planning, please visit the author’s website, www.disinherit-irs.com, and click on “Advisor Resources”.