The Sales Pitch All High Earning Corporate Employees Will Hear: How Does a 2% Tax Rate Sound?

I have come across several high-earning corporate executives that are considering or already hold a cash value life insurance policy, also referred to as permanent life insurance. While a cash value life insurance policy is typically a terrible idea for a high-earning corporate executive, purchasing these products is understandable because they have a very effective sales pitch. Before we discuss the sales pitch, here is the takeaway.

The Takeaway

The sales pitch for cash value life insurance policies is effective because it presents you with a solution to two serious issues you need to resolve – 1.) Your family’s financial security and 2.) Your high tax bill.

The Cash Value policy provides a death benefit if anything happens to you and once the cash value of the policy accumulates after several years it allows you to withdraw tax-free loans against the cash value accumulation in the policy.

While a cash value life insurance policy offers one solution to these problems, there are other solutions that address the problems more efficiently and precisely.

Term life insurance efficiently covers your family’s financial security for 5-10% of the premium of a cash value policy. While you are not guaranteed the death benefit if you outlive the term of the policy or allowed to take out loans to fund retirement, you will have a surplus of cash to invest in better places than the cash value piece of a life insurance policy that your family may never even receive.

Instead of paying more in premiums for a cash value policy, use the surplus cash to increase contributions to a Deferred Compensation Plan, invest more in an after-tax account and/or make more tax deductive charitable contributions to a Donor Advised Fund.

Contributing to a Deferred Compensation Plan allows you to deduct taxable income in your highest tax years and pay a much lower rate on the distribution in retirement.

Investing in an after tax brokerage account eliminates paying any insurance company fees and can be passed to your heirs when you pass away while the insurance company would keep the cash value accumulation.

If you plan to donate to charity in retirement, a Donor Advised Fund allows you to deduct taxable income during your highest tax rate years and parse out the money to charities in future years.

Ok, here is the sales pitch that many of you have heard and, if not, I am sure you will soon.

The Sales Pitch

Insurance Salesman: How does paying a 2% tax rate during retirement sound?

You: Taxes are one of my biggest pain points. Paying a 2% tax rate sounds great!

Insurance Salesman: Here is how it works. Right now, you want to invest in your pre-tax 401(k) and after-tax brokerage account, but your remaining assets should be invested in a Cash Value Life Insurance policy.

You: Ok. I do the first two things, but what is this insurance policy?

Insurance Salesman: First, a Cash Value Insurance Policy provides a death benefit to protect your loved ones in case anything happens to you.

Second, and here is the kicker: It lets you invest dollars that grow tax free. When you need income, you simply take out a loan (and pay interest) against this cash value. For example, if you need $150,000 per year in retirement, you could withdraw $50,000 from your IRA, $50,000 from your brokerage account and take out a $50,000 loan against your cash value. You would only pay around $3,000 in taxes on $150,000 which is 2%.

You: So, my family receives a death benefit payout if anything happens to me AND I can generate tax free income via taking out loans against the cash value to supplement my other income streams?

Insurance Salesman: That is correct. Let’s schedule some time for you to come into the office and we’ll talk about the details.

And….scene.

Pardon Me, You have some problems and I have just the Solution

Yes, you are a successful businessperson and you would have asked much more inquisitive questions – similar to how you may drill a junior analyst that is shooting from the hip - but the sales pitch is effective because it hits two things that are important to you: your family’s financial security and high taxes.

It is a typical sales pitch in that it presents you with problems and then offers you the solution. In this case, there are two problems:

1.) You Family’s Financial Security if you Pass Away

2.) You are Paying Too Much in Taxes

In this article, I’ll discuss why cash value permanent life insurance is not the best solution to these problems and offer a more efficient approach. You have likely been approached by someone offering the above sales pitch – if not, it is only a matter of time – and I want to provide you with the knowledge to ask the right questions. Here is a Forbes article (https://www.forbes.com/advisor/life-insurance/cash-value-life-insurance/) discussing the pros and cons that I believe is fair.

Now, let’s discuss the two problems addressed in the sales pitch and some alternative solutions to the permanent life insurance policy approach.

Family’s Financial Security

Sorry, time for a couple of definitions. Permanent life insurance, or cash value life insurance, pays a death benefit whenever you die as long as you stay current on the premiums. Universal and Whole Life Insurance are types of Permanent Life Insurance. Term life insurance pays a death benefit if you die within a pre-determined time frame (e.g. the next 20 years).

Your family’s financial security absolutely needs to be addressed, but a term policy is typically sufficient for a fraction of the cost. If you are a high earning executive with multiple years of 6-7 figure income ahead of you, it is extremely important that you protect that income via an insurance policy. This is income that will be used to pay for your family’s living expenses, children’s education, mortgage, your spouse’s retirement, children’s weddings, etc.

The permanent life insurance policy premiums are more expensive – typically around 10x term premiums - because the coverage lasts your entire life (i.e. the insurance company knows if will have to pay you at some point) and part of the premium is allocated to the cash value which grows tax free at a fixed rate or is tied to the stock market. You are allowed to borrow against the cash value, but your family does not typically receive any of the cash value when you pass away, just the death benefit.

In order to protect your family’s financial security, buy the less expensive term policy – probably a 10 – 30 year term. Term policies premiums can be as little as 5 – 10% of a permanent policy premium. Then, let the savings work for you in a more efficient way. Wait, but doesn’t the permanent policy offer significant tax advantages that make up for the higher cost? Absolutely not….

Taxes

A high-earning corporate executive has a tax problem, but that problem is not a high tax rate in retirement. The problem is a high tax rate RIGHT NOW and purchasing a cash value life insurance policy with after tax dollars does not solve the real issue. I assume that you are already contributing the maximum dollars to your 401(k), Health Savings Account and any other tax advantaged account. If not, allocate more dollars to these accounts that allow you to defer or even eliminate taxes. Here are 3 alternative options you have versus investing in a Cash Value Insurance Policy.

Deferred Compensation Plan – If you are eligible to participate in your employer’s deferred compensation, this is a great way to significantly reduce your taxes. The dollars contributed are not taxed, the dollars then grow tax-free and you will pay taxes on the distribution during retirement when you are in a much lower tax bracket. This solves the real tax problem of deferring taxes right now. For example, you defer taxable income today that would have been taxed at 37%, allow the contribution to grow tax free and then pay a 10-20% tax rate on the distribution during retirement. You are keeping around 20% more of your earned income as opposed to paying the IRS. This is a no-brainer if you work for a large healthy company.

Please remember that contributions to a deferred compensation plan are not guaranteed and in the case that your employer declares bankruptcy you will become a creditor. For a large and healthy Fortune 500 company, contributing to the Plan during your final 10 years of employment and taking distributions for the first 10 years of retirement typically makes sense (for a total of 20 years in the Plan), but do your research or work with an advisor that can spot any red flags.

Brokerage Account – Second, you simply invest after-tax dollars into an investment account. Yes, you paid taxes on the income (just as you would with purchasing a life insurance policy) and it does not grow tax-free. But, as long as you invest in tax-efficient securities – such as low-cost index funds – and avoid generating significant capital gains taxes through frequent trading, the tax liability is not a huge issue and you will likely still come out ahead because you avoid paying the fees associated with cash value policy.

These fees include the salesman’s commission, the operating cost of the insurance company, the life insurance company’s profit and investment management fees on some policies. While the fees on policies will vary, there is a lot of infrastructure around cash value life insurance, and everyone needs to get paid which means less dollars for you. And, just as important, the value of the brokerage account will pass to your heirs when you die, while the cash value accumulation in the insurance policy is returned to the insurance company. It is confusing and when it comes to financial products, simplicity is better.

Donor Advised Fund – Finally, if you gift to charity and plan to continue gifting throughout retirement, you can advance these future tax-deductible charitable donations to today while you are in a high tax bracket. The Donor Advised Fund allows you to take the tax deduction during your high tax rate years and then parse out the gifts over several years extending into retirement. The point here is that the tax deductions are worth significantly more while you are in a high tax bracket compared to retirement when you likely pay a much lower tax rate. This approach likely is used in combination with the Deferred Compensation Plan and investing in an after-tax brokerage account.

The most important thing is to identify what your problem is and determine the best approach to solving that problem. An effective sales pitch can convince you that you have a much bigger problem than you really have. For a high-earning corporate employee that receives a W-2, the truth is that there a not a lot of levers to pull to reduce your tax bill. There are a few such a Deferred Compensation Plans, 401(k)s and a tax efficient approach to investing after tax dollars, but a cash value life insurance policy is likely not the best solution to reduce your lifetime income tax bill.

Mark Chisenhall, CFA is the founder of Taurus Financial Planning, a wealth management firm specializing in helping high-earning corporate executives reduce taxes, optimize investments and accelerate retirement. If you are interested in learning more about the firm, you can schedule an introductory call here.

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