A Tool to Reduce Tax Liability for High Net Worth Investors
With recent changes to U.S. tax law, high net worth investors increasingly are looking at new strategies to help them mitigate their increased tax liability, especially related to investment income. One such strategy, private placement life insurance (PPLI)—a unique form of variable universal life insurance designed fo r buyers that meet the definition of a “qualified purchaser” has gained attention among ultra-affluent clients, family offices and institutional buyers.
Traditional life insurance buyers typically view insurance premiums as an “expense” and often are looking solely to maximize their policies’ death benefits relative to the premiums and cash value. While most buyers of private placement life insurance also are looking to provide a reasonable amount of death benefit leverage, unlike the traditional life insurance buyer, the PPLI investor tends to focus on more of the “living benefit” of the policy: its tax-efficient cash value accumulation.
As with all properly structured life insurance plans, the cash value inside the PPLI policy grows on an income tax-free basis while also providing an income tax-free death benefit to its beneficiaries. Additionally, the cash value inside the policy is accessible by policy owners on an income tax-free basis through a return of their original premiums and policy loans. Additional benefits of a PPLI product often include no surrender charges or large upfront commissions along with the elimination of headaches related to K-1s, 1099s and capital gain/loss reporting. Tax-deferred growth combined with a tax-free income stream creates a compelling financial and investment planning vehicle for investors subject to top marginal tax rates.
As interest rates have moved to historically low levels and most investment asset classes offer relatively low yields when compared to their historical averages, many investors have looked to add alternative investments such as alternative investments to their portfolios for more consistent, less volatile investment results. Along with liquid investment strategies through some of the top money management firms in the industry, the exclusive nature of PPLI allows only qualified individual and institutional buyers to invest the underlying policy’s cash value in private placement investment vehicles such as private equity and hedge funds. It is common for hedge funds source of returns to be generated in the form of short term capital gains or investment income—both of which are subject to top marginal income tax rates. In many states, this results in total tax costs of well over 50% of the funds’ returns. For many taxpayers this “drag” from taxes has become by far the largest detractor of net returns, greater in many cases than fees, commissions, trading costs and inflation combined. It should be noted that investors purchasing hedge funds in PPLI are subject to similar fee structures inside those funds as they would if they were to invest in similar funds outside of the PPLI.
Consider a healthy 55 year-old couple’s portfolio of hedge funds with average returns at approximately 7–8%. This couple is at the top marginal tax rate, making the cost of taxes in their hedge fund portfolio approximately 3.5–4%—or cutting their total return in half. Alternatively, they could pay between 0.75–1.25% in total insurance charges relative to their cash value with a similar investment structure in a PPLI policy. As noted in Table 1, the after-tax internal rate of return on both the cash value and death benefit of PPLI is quite substantial.
Private placement life insurance has never been more attractive to the ultra-affluent client than in our current tax and investment environment. Its unique features make it extremely valuable as a tool to help families achieve their investment goals, desired retirement income and wealth transfer objectives, all in one highly efficient and versatile product (see Table 2).
First Republic Private Wealth Management encompasses First Republic Investment Management, Inc. (“FRIM”), an SEC-registered investment advisor, First Republic Securities Company, LLC (“FRSC”), Member FINRA/SIPC, First Republic Trust Company (“FRTC”) and First Republic Trust Company of Delaware LLC (“FRTC-DE”). FRIM, FRSC, and FRTC-DE are wholly owned subsidiaries of First Republic Bank. FRTC is a division of First Republic Bank. Investment advisory services are provided through FRIM. Securities brokerage services are provided through FRSC. Trust and fiduciary services are provided through FRTC and FRTC-DE. Insurance agency services are provided through First Republic Securities Company, LLC, Member FINRA/SIPC, DBA Grand Eagle Insurance Services, LLC, CA Insurance License # 0I13184. This document is for information purposes only and is not intended as an offer or solicitation, or as the basis for any contract to purchase or sell any security, or other instrument, or to enter into or arrange any type of transaction as a consequence of any information contained herein. All analyses and projections depicted herein are for illustration only, and are not intended to be representations of performance or expected results. The results achieved by individual clients will vary and will depend on a number of factors including prevailing dividend yields, market liquidity, interest rate levels, market volatilities, and the client's expressed return and risk parameters at the time the service is initiated and during the term. Past performance is not a guarantee of future results. Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Although information in this document has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness, and it should not be relied upon as such. This document may not be reproduced or circulated without our written authority. The investment services and products mentioned in this document may often have tax consequences; therefore, it is important to bear in mind that FRIM does not provide tax advice. The levels and bases of taxation can change. Investors' tax affairs are their own responsibility and investors should consult their own attorneys or other tax advisors in order to understand the tax consequences of any products and services mentioned in this document. Investment and insurance products and services are not deposits of, or guaranteed by, any bank, are not insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other government agency, entity or person and are subject to investment risks including the possible loss of principal.