IRA Rescue Using a Three Pay Cash Value Life Policy (CVL)
This IRA concept is one that has reared its ugly head really starting in 2013 (although it really didn’t take off until an insurance marketing organization (Peak) started heavily marketing it to a bunch of unsuspecting/ignorant insurance agents).
How does it work?
1) Take some of, if not all, of the money out of your IRA over a three-year period (try to do so in equal installments).
2) Pay taxes (and penalties if under 59.5 years old) on the distributed money from the IRA.
3) Take the remaining money each year and fund a Cash Value Life (CVL) policy.
4) Let the money grow in the CVL policy tax free.
5) Remove money tax free from the policy when needed for retirement income.
On paper, I can make this work. However, in the real world, it will be an epic failure that will cost thousands of unsuspecting people some of or most of their retirement savings.
7702 Problem—in addition to the fact that the math behind IRA Rescue is bogus, there is an additional tax code problem with 7702. To read about this problem, please click here.
Paying the taxes—one of the biggest impediments to making IRA Rescue using CVL work is where do you find the money to pay the taxes on the IRA distributions? This is such an important/deceptive part of the sale’s pitch that I created a separate page to discuss it. Click here to learn more.
If you actually pay the taxes from the distributed money from the IRA, there would be no chance to make this concept work.
Example 1—the best way to explain why this strategy doesn’t work is to go through an example. Example 1 is for a 58 year old (so there is a 59.5 age issue with a 10% penalty for early withdrawals). Assume the client has $1 million in his IRA.
1) Remove $333,333 taxable distribution from the IRA every year for three years and pay that as a premium each year into the CVL policy.
FYI, when you pay premiums for only three years, the bi-product is that the death benefit has to be raised significantly to avoid the 7702 tax problem; and the commissions are triple the size of a policy with premiums spread over seven years or longer (which is the ideal time frame to pay premiums in order to reduce costs and increase cash value, growth, and tax-free borrowing).
Where do you get the money to pay taxes on the distribution? Well, of course, you take “tax-free” loans from the life insurance policy to pay the taxes. This way an insurance agent can sell the concept without any other out-of-pocket costs and with the full amount of money from the IRA going into the life insurance policy.
2) Borrow $163,333 from the policy in years 2-4 to pay the taxes on the IRA withdrawals.
Side note: illustrated crediting rate on cash growth—with an EIUL (Equity Indexed Universal Life policy (click here to learn more about them)), as an insurance agent, you can put in a wide range of assumed investment returns to use as assumptions in the policy. For this example, I’m going to use a “real-world” return (one that is likely to occur over time). That is not the norm in the industry. The norm is to use a much higher rate of return in an attempt to make the numbers look better. I will use a 7.7% rate of return on cash in the policy.
Side note: lending rates—the only chance to make IRA Rescue work is the insurance agent assumes in the policy that there is a large spread between the crediting rate and the borrowing rate on money borrowed tax free from the policy.
I don’t want to take space explaining the abuses that occur when it comes to the lending rate illustrated in EIUL policies. Needless to say, the abuses are significant. To download a summary so you can educate yourself on how “variable loans” work in EIUL policies, click here.
For this discussion, what you need to know is that, when you borrow money from an EIUL policy, the insurance company loans you money from its general account not from your policy. That actually leaves all the money in your policy to grow at market rates. This is a great thing if the money grows at a high rate and if loan rates stay low. It’s an absolute disaster if the policy doesn’t grow fast enough and/or if interest rates on the loan go up. All the illustrations I’ve seen on IRA Rescue use the highest possible crediting rate for growth and the lowest possible lending rate for loans (in other words as misleading as possible).
3) Let the policy grow until age 65 at which time the illustration shows borrowing from the policy in the amount of $92,000 a year tax free each year until age 100.
Sounds great, right? The client removed money from a taxable environment and put it into a tax-free environment.
1) In order to get a $92,000 loan from the policy, the illustration had to use a 3.45% positive loan arbitrage on the borrowed funds (which was assumed from year 2 of the policy and lasted every year for 43 years). This was in an EIUL policy that doesn’t have a fixed lending rate. Since the 50-year historical average lending rate on life policies is bit over 7%, I’d say this is as bogus as it gets.
2) If you used a lending rate just 1% higher, the borrowing goes down to $79,000 a year. Why did I not use the 7% historical average? Because the insurance company software only allows me to raise the rate 1% from its current 4.25% default rate. If I illustrated with a 7% loan rate, the client would barely be able to borrow any money out of the policy.
You think that a client should be shown for full-disclosure purposes an illustration with a 7% loan? I think so; and, heck, if the client was shown one with a 5.25% rate let alone a 7% rate, the agent would have no shot at selling this.
3) The numbers “as is” do not beat leaving the money in the IRA and investing it in low-risk tactically managed strategy (for information on low risk/high return investment strategies (my favorite manager has gone 23 years without a down year and a net 9% rate of return), click here to download my investment White Paper).
When I ran the numbers using my favorite low drawdown risk strategy, the client could remove $96,000 a year (net of taxes) vs. the totally unrealistic $92,000 in the IRA illustration created by the agent (way more than the $79,000 amount when I raised the lending rate only 1%).
The quick summary with this concept is that it’s a piece of garbage and should not be used. It’s a disaster waiting to happen; and if you’ve been pitched this nonsense, e-mail me at firstname.lastname@example.org or call me at 269-216-9978, and I’d be happy to further discuss why you shouldn’t use this strategy. If you were already talked into and implemented this strategy, contact me; and I’ll refer you to a personal injury attorney who specializes in these case who will try to get your money back.