December 2020

If an indexed universal life (IUL) insurance policy is structured properly, loans could be one of the most important features of an IUL for the right person and right circumstances.

And it could be especially important right now as  clients may be looking for extra sources of income — wondering what they own and how they can access it.

One source they may not have considered is an IUL. The distributions from an IUL can be a tax-friendly way to access money when a client needs it. However, there are many nuances to IUL loans and it’s extremely important to understand all the ins and outs before speaking to your client.

In this post, we’ll cover what you need to know about IUL loans so that you can help clients decide if this might be a good option for them.

A common misconception about IUL loans

Some agents might mistakenly assume that IUL loans are just like loans a client would take from their qualified plans, such as a 401(k), but that’s not the case at all. This is one of the reasons why it’s important to read this blog post because the subject of IUL loans CAN be tricky.

And we wouldn’t want– and we know you don’t want – a client to suffer because of a misunderstanding.

You’re going to learn a lot in this blog post, but we can’t cover every detail of how to set up indexed universal life insurance policies correctly so that clients can use a loan strategy for supplemental income.

Not to mention, we can’t get into carrier specifics. For example, a lot of financial professionals we work with are interested in hearing about the 90-day interest free loans where policyholders can take up to 90% of their cash value every two years because clients like this feature. If that sounds interesting to you, then you would want to schedule a call with a Partners Advantage representative.

But we’ll cover as much as we can here, so let’s dig in.

Right now, your clients may be considering taking money from their retirement accounts to help fill a temporary income gap even though:

• A loan from a qualified plan like a 401(k) would need to be paid back within certain timeframes with interest.
• They may be not be able to get as much as they need due to limits on the amount they can take out, generally up to 50% of the account value.
• It’s likely the money loaned out won’t be working for them, which means they lose the benefit of compounding interest on that amount.
• They could be forced to pay back the loan from their qualified plan immediately if they are fired, quit or are laid off from their job.

Rather than going the route of taking  money from their retirement accounts and potentially setting themselves up for a worse situation down the road, some clients might want to consider the benefits of taking a loan from an IUL policy instead.

Here’s why:

• The loan taken from an IUL is not actually taken “out” of the policy. The IUL loan comes from the insurance company and the life insurance policy is used as collateral. Policy loans are an asset to the insurance carrier, just like a bond they purchased.
• The money is coming from the insurance company. If you’ve ever heard someone skeptical about taking a loan from a life insurance policy say, Why would anyone pay to borrow their own money??, here’s the thing… a client ISN’T “borrowing their own money.” They are taking it from the insurance company.
  And as you’ll see a little further into this post…
  A client could end up paying nothing to take the loan from the insurance company, in some cases.
  More on that later!
• A policyholder would not be required to set up a payment schedule to pay back a loan from an IUL , although paying it back would probably be in their best interest especially since any IUL loan not paid back at time of surrender plus any accrued interest (and possibly penalties and fees), would be deducted from the surrender value. And at time of death, the loan and any accrued interest (and possibly penalties and fees) would be deducted before anything is paid out to the beneficiary. 
• If the policy is properly structured, loans (and withdrawals) would be tax-favored. Meaning, the client would not pay income tax on those distributions because an IUL that is set up properly follows a first-in first-out (FIFO) method for distributions. Income tax free distributions are achieved by withdrawing to the cost basis (premiums paid), then using policy loans. This assumes the policy qualifies as life insurance and is not a modified endowment contract. Keep in mind, loans (and withdrawals) may generate an income tax liability, reduce available cash value, and reduce death benefit, or cause the policy to lapse.
• The loan amount that could be taken from an IUL could be between 80-95% of the cash value, based on the carrier.

Now let’s get into the types of loans you would find on IUL. Some insurance carriers may only have one type, but most typically have at least two different options for clients. If you need help choosing a carrier that offers loan options to meet your clients’ needs, don’t hesitate to reach out to your representative at Partners Advantage.

What are the different types of IUL insurance policy loans?

FIXED

This is the traditional loan structure and most IUL has this option. To understand how it works, let’s assume 100% of the cash value is allocated to indexed strategies.

The fixed loan carrier takes the loaned amount out of the indexed strategy and puts it into a fixed strategy (this is known as a “non-participating” loan because it’s not participating in the index growth).

Now, the loaned amount grows at a fixed rate.

The net cost of loan?

This would be the difference between the loan rate and fixed crediting rate.

Also, many carriers will offer what’s referred to as a “wash” loan or “zero net cost” loan, which means the fixed crediting rate and loan rate are the same. This is generally available around the 10-year mark of the policy.

Next big question: How is the loan rate determined?

The fixed loan is a factor of the fixed crediting rate. As we mentioned above, in a “wash” loan, the loan rate equals the crediting rate and changes with the crediting rate. Other situations may stipulate the crediting rate plus a percentage rate to calculate the loan rate, typically ranging from .10% to 1%.

When taking a fixed loan, it typically makes sense to withdraw dollars to basis and loan out residual dollars above and beyond premiums paid into the policy.

 

VARIABLE/PARTICIPATING

With a variable loan, the amount of the loan can stay in the indexed crediting strategies. So that amount continues to grow as the index grows and the loan has a floating rate tied to Moody’s Corporate Bond Yield Average.

If the average crediting rate is greater than loan rate, this leads to positive arbitrage…

If you could borrow at 5% and reinvest at 7% you‘d do it all day long, right? — That’s the benefit of a variable loan.

And in an illustration, this is assumed, but there is a limit to what can be illustrated. We’ll get into that more here shortly because that is about to change when AG 49A takes effect.

Now, if the loan rate is greater than crediting rate, which is bound to happen at least one year, then there is an actual cost to the loan. But it’s good to focus on the long-term average.

Here are a couple of examples to illustrate these scenarios:

Average Moody’s CBY: 6.0%

Average Index Credit: 8.25

Benefit of borrowing: 2.5%

 

However, there is a chance to get upside down on a year-to-year basis.

Annual Moody’s CBY: 5.5%

Actual Annual Index Credit: 0%

Cost of Borrowing: 5.5%

 

The biggest risk with a variable loan is an increase in interest rates associated with the policy. To address this, insurance companies came out with Indexed Loans.

INDEXED/PARTICIPATING

Indexed loans reduce the risk of higher loan rates and typically replace the variable loan structure. They work similar to them, but the loan rate is capped or fixed at a lower rate (5-6%).

These types of loans are typically marketed as the best of both worlds.

Because loans are an asset to the insurance company as we mentioned previously, if interest rates rise, the carrier is forced to buy lower yielding assets, which reduces their portfolio rates, which in turn, reduces crediting rates.

So, let’s say you have a 5% loan rate.

Interest rates are at 8%.

So, loaning at 5%, they would be forced to significantly reduce crediting rates, which means all clients pay for loans in that they will have lower cap rates. Unless, you work with a carrier that has a way to help prevent that from happening. Ask your Partner Advantage representative more about this.

Now, one way that risk could potentially be reduced is if carrier has all three loan options. Many carriers have this, and some allow multiple types of loans to be taken. Others may require only one loan type be used at a time.

In our time working with IUL agents, we’ve had many ask which loan their client should do.

 

What’s the appropriate loan choice to use with clients?

Our answer is “it depends,” because what’s most favorable will depend on each person’s unique circumstances. So, we almost always suggest showing different options. Mainly because a client doesn’t have to choose the loan option until they actually take the loan.

Additionally, a client can switch loan types usually at least once a year. Some carriers allow you an option of all three.

Using a carrier that has that type of flexibility puts the client in the best position to decide which is better for them depending on the current economic environment.

What type can depend on a client’s risk tolerance as they may choose to be more conservative entering into retirement. But you could say in a general sense that:

• If interest rates are low and cap rates high, a variable loan option makes sense.
• If both interest rates and cap rates are high, they may be best off using an indexed loan strategy.
• And if interest rates are high, and cap rates low, a fixed loan probably makes the most sense.

One of the important things to remember though in running these illustrations is to run variable loan illustrations with realistic expectations. AG 49A is scheduled to go into effect on December 14, 2020, and will further level the playing field when it comes to variable loan arbitrage in illustrations.

Up to this point, we’ve talked a lot about taking loans from an “overfunded, properly structured IUL.” And the point we want to reinforce is that not all life insurance policies work the same and just because someone purchases an IUL or any life insurance policy, it doesn’t mean they’ll be able to use it effectively to supplement their income in retirement, or for any other reason, using loans.* That’s why it’s so important to reach out to those who have accumulated years of expertise on IUL like the team here at Partners Advantage.

Next, let’s talk about what a Modified Endowment Contract (MEC) is and how that changes loans coming out of the policy.

What’s the impact of a MEC on loans/withdrawals?

A life insurance policy that meets the requirements of Section 7702 that was entered into on or after June 21, 1988 and fails to meet the 7-pay test (or was exchanged for another modified endowment contract), is considered a modified-endowment contract (MEC). (Source)

If the policy fails the 7-pay test and becomes a MEC, any loan or withdrawal is taxed using last-in first-out method, just like a non-qualified annuity.

Plus, with a MEC, if the client is under 59 ½ and they aren’t disabled or taking the distribution in the form of a life annuity, a 10% additional tax will apply to loans and withdrawals.

Essentially it loses its tax favorability on cash-value distributions, however, the death benefit will remain income tax-free to the beneficiaries.

So, why would someone purchase a MEC?

From a cost of death benefit standpoint, this is often the most efficient use of a premium dollar per dollar of death benefit within a permanent policy. Additionally, clients appreciate having access to their premium dollars if they ever need it, but they don’t plan to use it as income long term.

 

How will AG 49A affect IUL loans?

As mentioned, revisions to AG 49 – dubbed AG 49A — will go into effect on December 14, 2020. If you’re not familiar with the changes coming as a result of that, you can check out a recent article featured in the NAILBA Perspectives magazine that goes over this new regulation quite well.

When it comes to loans, AG 49A will drop the maximum arbitrage allowed from 1% to 50 basis points. As a reminder, arbitrage is the difference between the loan rate and the average crediting rate. This will lead to more conservative illustrations, but it doesn’t diminish the value of IUL or the ability to use loans in the way we’ve described.

 

In conclusion…

The ability to take a loan from an IUL creates numerous benefits for a policyholder. Whether they potentially take a loan because they need to fill a temporary income gap, pay down debt, fund college tuition for their kids, buy a car, supplement their retirement income – or any other expenses that might come up — they have a tax-advantaged way to do that. IF the policy is structured properly.

If you’d like to help you clients not only address mortality concerns and leave a tax-free legacy for their beneficiaries, but also help them utilize other benefits like accessibility to the cash value through loans –

Contact your RAM GROUP representative today to discuss which products are best suited for this strategy AND how to set up the policy in a way that can help your clients achieve their goals.

FOR AGENT/BROKER USE ONLY

Original Author: Lori Fogle

This content is for informational and educational purposes only and is not designed, or intended, to be applicable to any person’s individual circumstances. It should not be considered as investment advice, nor does it constitute a recommendation that anyone engage in (or refrain from) a particular course of action. This information is written in connection with the promotion or marketing of the matters addressed in this material. The information cannot be used or relied upon for the purpose of avoiding IRS penalties. These materials are not intended to provide tax, accounting or legal advice. As with all matters of a tax or legal nature, your clients should consult their own tax or legal counsel for advice.