Variable Universal Life to Pay for College?
Published on December, 14, 1999

[Great Robert Mankoff New Yorker cartoon caption (guy speaking on the phone in his skyscraper office): "No, Thursday's out. How about never -- is never good for you?"]

"My question is, do you have an opinion about Variable Universal Life Insurance for a young, recent widower dad with a chunk of life insurance proceeds who wants to use VUL in part as a tax-free growth investment to fund college for two young children? I'm getting conflicting opinions which seem mainly to be based on the age of the person giving the advice. Older people say 'no way,' and younger people say that it's a great idea. The tax-free nature of the growth is attractive -- very attractive -- but the fact that it is a life insurance policy is not attractive at all. My financial planner, who will sell it to me if I want it, is -- not surprisingly -- in favor of it. (But he hasn't pushed it on me; he's mainly responding to my request for a way to grow assets without paying taxes where possible.)" -- Frank Isaacs

Over the years, I've made life insurers pretty angry. Rather than rub salt in the wounds, I asked my friend and tax expert Less Antman to do it for me. Let the life insurance guys hate him. He is a Taoist, so hate just bounces off him and is returned as love. (Or something like that.) Anyway, he is a very fine soul.

Less writes:

<< Older people say 'no way,' and younger people say that it's a great idea. >>

"I must be a VERY old man! The punch line, of course, is going to be 'buy term life insurance and invest the difference in index funds,' but before we arrive there, let's take a look at the supposed tax advantage of VULs and the many -- many -- disadvantages.

"(1) Income in a VUL is not tax-free, it is only tax-deferred. Once the income is withdrawn, it is taxed at ordinary income rates, even if the income resulted from long-term capital gains within the policy. If Frank is in the 28% federal tax bracket, having income tax-deferred for 15 years and then withdrawn is equivalent to paying an annual tax rate on the earnings of 18%. [It's not intuitively obvious; Less has done the math.]

"This can be bettered easily by leaving the money in index funds, since (a) only the dividends are taxed annually, (b) the capital gains are deferred unless and until the shares are sold, and (c) at that point the tax rate will only be 20%. It is hard to determine the exact effect, but it probably works out to the equivalent of a 15% rate applied annually.

"For someone in the 31% federal bracket or higher, the comparison is even worse for the VUL. And if the index funds are kept in the name of the children, the effective tax rate on ordinary income will be 15%, and the eventual tax on the long-term gains 10%. And the first few hundred dollars each year will be taxed at a rate of 0%!

"(2) The income within the VUL must be distributed and taxed sooner or later, even if the policy owner dies. Capital gains in a mutual fund disappear automatically upon death. All of the assets in the VUL, including the insurance benefit, are included in the assets of the decedent for estate tax purposes. This is also true of mutual fund assets, but many people are deceived into believing that insurance benefits and VUL assets bypass estate taxes. They only bypass the legal process known as probate for settlement of the estate, and mutual fund assets can duplicate this by the use of living trusts, joint tenancy, or transfer-on-death designations. He probably should establish a trust for the protection of his minor children in any event.

"(3) It is often mentioned that the insurance premiums can be paid from the income of the VUL, thereby making some of the income tax-free. What isn't mentioned is that the insurance charges within a VUL policy are, on average, enough higher than term policy rates that the tax-free status only reduces the net cost to approximately the same amount as the term cost. Furthermore, the policies often require the continuation of insurance well beyond the point that need has ended (for instance, once all children are grown), because a policy that ceases to have a sufficient insurance element may be declared a modified endowment by the IRS, causing all income to be immediately taxed and subject to pre-age 59 1/2 withdrawal penalties. But just try to get an insurance agent to explain simply the maximum funding rules and the seven-pay test (I know I can't).

"(4) The average VUL has a sales load of 4%, state governments assess a premium tax averaging 2% (raising the effective sales load to 6%), setup costs average $400, and annual fees average $70. It will take close to 10 years for the benefits of deferring taxes on dividends to just recover the initial costs of the policy (the additional cost in the form of higher tax rates on withdrawals cannot be recovered within the expected lifespan of the universe). But that's okay, because the insurance company and tax penalties that result from terminating most VULs within the first 15 years are so high early termination will be unthinkable anyway.

"(5) Although most VULs allow policy loans, these must be fully collateralized by transferring an equal amount out of the investment accounts of the VUL and into cash accounts that earn interest 1-2% less than the interest rate that will be charged the borrower (not to mention the typical $25 fee to process each loan request). The interest paid to the insurance company is NOT deductible (and is not adding to the value of the policy), but the interest earned on the cash account will be taxed upon withdrawal.

"(6) The cash value available to borrow is substantially less than the sum of the premiums and income. The overpriced insurance premium and expenses obviously reduce that is invested, most policies limit loans to 90% of cash value, and they won't lend the surrender charge (which takes 10 to 15 years to phase out).

"It is no wonder that the head of the insurance analysis division of the Consumer Federation of America recommends against these policies, and that the SEC is planning to start an investigation into them shortly, due to the enormous number of complaints of policy holders.

"Now, let's see how the reader can better accomplish his objectives.

"(1) Buy term life insurance for the amount needed, choosing a policy with guaranteed premiums for 20 years to take care of his small children until they are no longer dependent on him. He can reduce the coverage later if he doesn't need as much, both without penalty and without fear it might trigger terrible tax consequences.

"(2) Invest the rest equally in two stock index funds, one of U.S. stocks, the other international (such as Vanguard's Total U.S. Stock Market and Total International index funds). Pay the miniscule annual taxes resulting from the dividend distributions, which will undoubtedly be less than the expenses of a VUL.

"(3) To reduce taxes further, consider these strategies: (a) take margin loans against the value of the shares once the kids start college, instead of liquidating shares, (b) keep track of the purchases and reinvestments in the mutual funds so as to sell higher cost shares first, and/or (c) transfer assets into Uniform Transfers to Minors Act (UTMA) accounts for the kids so that the income is taxed at their lower rates. If the last is chosen, these can be transferred in annual amounts that don't exceed the gift tax return exclusion limit ($10,000 per child per year at the moment, indexed for inflation), or larger sums can be transferred, using part of the available lifetime exclusion now instead of later. There is good reason to believe that the lifetime exclusion will be increased enormously within a few years by the federal government, so this might be a costless transfer. The sums transferred to the UTMA accounts do belong to the children once they reach 18 or 21, depending on the state. A threat to disinherit should help encourage them to spend it on college, though!

"For details on saving this way, he should read chapter 6 of The Only Investment Guide You'll Ever Need, keeping in mind that he should fund his own retirement accounts to the maximum degree possible since he can withdraw that money without penalty for college tuition as well if necessary. Furthermore, many of the arguments against variable annuities in the book apply to variable universal life.

"I think there is a very important general lesson that people need to learn sooner or later. Complicated strategies ALWAYS have a catch, but the complications make them hard to catch, and by the time the catch is caught, the investor is caught. And there must be some rule worth inventing that any investment which penalizes you for changing your mind in the next 10 years must have a reason for not wanting to let you change your mind for the next 10 years.

"Now, time for the punch line: BUY TERM LIFE INSURANCE AND INVEST THE DIFFERENCE IN INDEX FUNDS. "Okay, I need to get back to work. Love, Less."

Is your tax advisor a Taoist? Should be.

1998, 1999, Andrew Tobias