Should You Use Whole Life Insurance to Hedge "Legislative Risk"?

After publishing “Correspondence With A Whole Life Insurance Salesman” I had a friend publicly state that he felt some of my arguments could use further explanation.

What followed was an interesting exchange that is ongoing as of this writing.

Here’s one of the more interesting comments that my friend made:

“I believe that most [financial advisor]’s ignore the biggest risk that clients have ... legislative risk. The reason most do is because they are taught that the main goal is to grow their clients money. But who are they growing their money for? Many/most [financial advisor]’s grow it for 4 “people”, the [financial advisor], the company, the client and potentially the biggest beneficiary and greediest partner of the 3 ... good ole Uncle Sam. I believe I remember reading that your fee only and while I admit I don’t know exactly what that looks like I would assume that this fact could easily absolve you from this. BUT it doesn’t mean that you haven’t been, taught “wrong”. I’d love to hear more about how you’re paid. Are you insurance licensed? If so is the “incentive” the same? Are your support channels equal?  Or do you have the bias that most in our industry have? My agents don’t need to sell life or investments or annuities to feed their families.

“As for Whole life. For high net worth individuals that don’t like risk. What avenues exist to help them avoid (or help them get out of) that greedy partnership? This is a big deal. For some the [death benefit] is the least attractive feature.”

There are a lot of great topics to discuss from the above statement—certainly more than could be addressed in a single article. But I thought that I’d consider my friend’s argument that “legislative risk” makes whole life insurance attractive to high net worth individuals.

It’s worth noting that my friend has been an Area Sales Executive for a national property and casualty insurer for almost five years. Prior to that, he was an insurance agency owner for almost five and a half years with the same national property and casualty insurer.

“Legislative risk” defined.

The way my friend uses the term “legislative risk” is distinct from my understanding of it. Here he uses it to highlight the possibility that the government increases taxes in the future.

My understanding of “legislative risk” is along the lines of what I found here where it is defined as “[t]he risk of loss due to a change in law in a particular jurisdiction . . . legislative risk deals with changes such as requirements to provide more benefits to employees or free trade agreements that make an industry less competitive against its foreign counterpart.”

The point of all this is to highlight the fact that it’s important to speak the same language. My friend here is referring to the risk that taxes may rise in the future, rather than the possibility that the government passes a law affecting a particular company or industry that makes it less competitive and profitable.

So the real question we are seeking to address is if whole life insurance is a good place to stuff cash to protect from potential future tax increases.

Is whole life insurance a good tool to use to protect against future tax increases?

My friend again: 

“As for Whole life. For high net worth individuals that don’t like risk. What avenues exist to help them avoid (or help them get out of) that greedy partnership? This is a big deal. For some the [death benefit] is the least attractive feature.”

Many “financial advisors” believe that whole life insurance is a useful tool to protect against future tax increases. My friend asked about the avenues that exist to help taxpayers avoid “that greedy partnership.” He further notes that for some individuals, the “DB” (whole life policy death benefit) is the “least attractive feature.” In other words, the cash value and “tax-free” withdrawals provided by whole life insurance is more attractive.

In terms of providing tax-free income, many advisors who sell whole life for its tax qualities ignore the fact that an increasing number of individuals have Roth 401(k) options through work. If you do, in 2019 you can contribute up to $19,000. If you’re over 50, you can make an additional $6,000 contribution, bringing your total contribution up to $25,000 in 2019. This amount may be invested as aggressively or as conservatively as you like. In a qualified distribution, contributions AND earnings are not taxed. This is according to the IRS website found here.

That seems like a pretty good deal for tax-free income in the future.

But what if you don’t have access to a Roth 401(k)? In that case, you, and your spouse if married, can contribute to a Roth IRA. In 2019 individuals can contribute up to $6,000. That’s $12,000 if you’re married. If you’re over 50, you’re allowed an additional $1,000 each, bringing the total household Roth IRA contributions to $14,000 if you’re married.

But isn’t it true that if you make “too much money” you can’t contribute directly to a Roth IRA. Yes it is. But, the IRS allows income earners above the direct Roth IRA contribution limit to perform what is commonly known as a “Back Door” Roth IRA in which the taxpayer makes a nondeductible traditional IRA contribution and subsequently transfers it to a Roth IRA. Similar to the Roth 401(k), Roth IRA contributions may be invested as aggressively or as conservatively as you like. Additionally, during qualified distributions, contributions AND earnings are not taxed.

But what about whole life insurance and its tax benefits? In my opinion, these are secondary features that are touted as primary reasons to buy a policy. 

Whole life insurance may provide tax-free withdrawals from the policy’s cash value, but it’s not as exciting as you might think. First, cash value amounts that are considered contributions (premium payments) may be withdrawn tax-free. There is truly nothing special about this. The same tax treatment is true for money you put in your piggy bank. 

If there is growth in the policy cash value beyond your contributions, however, it may be withdrawn tax-free—AS A LOAN! 

Though you won’t pay taxes on the policy loan, it will accrue interest. A client of mine has a whole life policy (sold by a prior “financial advisor”) that states the loan interest rate is 8%. How exciting does it sound to pay interest on a loan so that you can have tax-free income?

If you were sold a whole life insurance policy for its tax-free income benefits, was that little detail explained to you? 

For those who don’t want to take out their whole life policy cash value growth as a loan, they are still free to do so. But they will be taxed at ordinary income tax rates.

How your advisor gets paid really matters.

Once more from my friend: 

“I’d love to hear more about how you’re paid. Are you insurance licensed? If so is the “incentive” the same? Are your support channels equal?  Or do you have the bias that most in our industry have? My agents don’t need to sell life or investments or annuities to feed their families.”

This comment reflects an interesting problem facing the financial services industry. As my friend notes above, “advisors” and agents are often conflicted in their advice because of how they get paid. For this reason, I often argue that how your advisor gets paid is the most important determinant of what your relationship with them will be like.

The consumer should reflect on whether or not they want their “advisor” to be paid on commission at all. My friend highlights that his agents “don’t need to sell life or investments or annuities to feed their families.” It’s still worth considering the fact that his agents will earn commissions on product sales, and therefore are financially incentivized to sell them if they want to get ahead. 

Fortunately, there’s a growing movement of financial advisors who are paid on a retainer basis. Clients pay a flat fee for comprehensive financial planning and investment advice. I’m one of those advisors. 

It is vital for you to know how your advisor gets paid so that you can determine what conflicts of interest they have. When advisors receive any form of commission from the sale of a product (whether insurance or investment) they will have a direct conflict that inhibits their ability to provide you with objective advice.

Some final thoughts.

Is whole life insurance bad? Not at all. 

There are a few situations where it can be useful—most often when the insured has an important reason for a guaranteed death benefit beyond the years that term insurance can provide. 

So it’s not that the product is bad. The problem is that it is often oversold by “financial advisors” and insurance agents who are incentivized to do so in hopes of earning a large commission.

Though I respect my friend, I don’t agree with his argument in theory or in practice. 

There are important tools that exist in order to help provide clients with tax-free income in retirement without the headache and complexity of incorporating whole life insurance into the plan. Additionally, there are some very good reasons to defer income if you are currently in a high tax bracket. Whole life advocates often point to a down-the-road scenario when taxes may rise. Will they rise in the future? I think so. Will they fall again at some point after they rise? I think so. The point is that I can’t predict the future, and neither can anyone else. So we take prudent measures to diversify from a tax perspective with the most efficient and effective tools available.

But if you’re currently considering a whole life insurance purchase for its “tax benefits,” consider having your policy and situation reviewed by someone who gets paid hourly, on retainer, or on a per project basis. It’s not hard to see why their advice may be more objective and conflict-free than that of the agent who will get a commission for selling you the policy.

For more of my writing and thinking, click here.

Disclaimer:

The content you just read is for informational purposes only. Yes, I’m a financial advisor, but this article really isn’t intended as advice for you specifically. Your unique situation needs to be taken into account, and the ideas presented here may not apply. 

So, please make sure you do your due diligence BEFORE implementing anything. Due diligence includes hiring a qualified professional who understands your situation completely and can offer you personalized advice.


Donovan Sanchez