How do I handle rising taxes?
August, 2011 | Portfolio Management: Creative Investment Strategies
By: Bill Loftus
As Published in Worth Magazine
Investors have recently enjoyed historically low tax rates, but given the current fiscal environment, taxes may increase on income, dividends and capital gains. Most investors do not pay enough attention to after-tax returns. We expect that to change.
Private placement life insurance (PPLI) and variable annuity contracts (PPVA) can offer significant tax-free or tax-advantaged investment benefits. In their simplest form, they are stripped down, low-cost insurance contracts. For example, with the annuity, there is no guaranteed income option. With private placement life insurance, the death benefit is not as robust as you would find in a traditional policy. Historically, private placement contracts have been used as a tax-free or tax-deferred way to invest in tax-inefficient asset classes such as hedge funds.
Hypothetical illustration of the benefits of tax deferral. Let us assume a 50-year-old investor, in a combined 35 percent tax bracket increasing to the proposed 43.6 percent in 2013 (remaining constant), places $10 million in a private placement contract to be invested in a portfolio of managed accounts or hedge funds. The portfolio earns 8 percent per year net of fees and expenses. Over 20 years, the investments held inside the private placement contract would grow to an after-tax value of $27.5 million, versus a fully taxable portfolio held outside the private placement that would grow to just $19.8 million.
Additional benefits. While the tax benefits are appealing, there are other positive considerations, some of which are: there is no K-1 tax-filing requirement; insurance contracts may provide asset protection in certain states; PPLI contract holders receive an income tax-free death benefit, providing valuable estate planning options; the PPLI contract allows tax-free policy loans as long as the policy is not set up as a modified endowment contract; you may reallocate among a variety of investment options on a tax-free basis and withdraw from the contracts without paying surrender charges; PPLI and PPVA contracts hold client assets in a separate account from the insurance company general account; and the fee structure is lower than traditional insurance contracts.
Considerations. There are restrictions associated with insurance contracts. In the case of the annuity, distributions from the contract prior to age 59½ are subject to a 10 percent penalty in addition to ordinary income tax. The appreciation on the contract is distributed first so most of the early distributions are fully taxable. At the death of the annuitant, the beneficiary of the contract must pay taxes, and the contract will not receive a step up in basis.
In the case of the life insurance contract, death benefits and policy loans are tax-free as long as the policy remains in force. If the policy lapses for any reason, it could cause adverse tax results for the owner. Finally, as tax-inefficient assets such as hedge funds are the best vehicles to place in these contracts, investors should be aware of the liquidity and market risks associated with the underlying funds.
Generally speaking, the assets placed in private placement contracts should have a long-term time horizon with no immediate need for liquidity.
PPVA OR PPLI; IS ONE RIGHT FOR YOU?
To invest in a private placement variable annuity or private placement life insurance contract, you must be an accredited investor and qualified purchaser ($200,000 annual income and investable assets of $5 million). Investments must be diversified into multiple investments. Additionally, policy owners are prohibited from directly controlling the investments inside the policy. The owner may select an investment advisor to invest the assets in accordance with general investment guidelines set forth by the owner.
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