Combining Economics And Taxes Can Make You A Big Winner

Chances are you've never even heard of the subject matter that we are about to discuss: viatical settlements (VS). A VS is a transaction involving an existing life insurance policy that is sold. Surprisingly, both the buyer and seller come out after-tax winners. Here's an example from the seller's side of the story. Joe, age 62, owned a life insurance policy on his life with a death benefit of $700,000 and a cash surrender value of $282,000 that was subject to a loan of $201,000. So Joe had equity of only $81,000.

An analysis of Joe's insurance situation clearly showed that he and Mary (his wife) could buy $1.2 million of second-to-die life insurance for the same combined annual premium and interest cost as Joe's old policy. Done! Joe and Mary created an irrevocable life insurance trust to own the new $1.2 million policy. The $1.2 million will ultimately go to their kids...tax-free.

The old policy was sold to an investment group in a VS for $157,000 in cash. It should be noted that Joe's obligation to repay the $201,000 loan was assumed by the investment group, so in effect, Joe got $358,000 ($157,000 + $201,000) for selling his policy. Over the years Joe paid $214,000 in premiums so the first $214,000 (of the $358,000) was tax-free. The balance—$144,000—is a profit on the sale of the policy and enjoys capital gains tax treatment at only 20 percent.

Now let's look at the other side—from the investor's viewpoint—of the VS story. A number of entrepreneurs have formed companies that seek out people who want to sell their policies in a VS. These same companies seek out investors to fund the policy purchases. Typically, according to the investment groups, the investors earn from 12 to 20 percent per year, sometimes higher. When the income from the VS is received, it is taxed as ordinary income. Of course, the income would be tax-free if received by a qualified plan (for example a 401(k) plan, a profit-sharing plan, or an IRA). Because of the potential high rate of return, you should consider a VS if you have funds in a self-directed IRA or any other type of qualified plan.

When The Baby Is Born, Call

Okay, you are a new Mom or Dad (or Grandma or Grandpa). Using the miracle of tax-free compounding you can use a small amount of money to create millions of dollars. Here's an example: Joe wanted to know what the retirement amount would be for his new grandson, David, if he put away $10,000 per year for seven years in a PRP (private retirement plan). The projected plan would allow the funds to accumulate until David attained age 65. Are you ready? David would get $698,381 every year to age 95. $21 million.

Actually, Joe would make a $10,000 gift each year (for seven years) to David to pay the premiums on a high cash surrender life insurance policy. If David were to die before age 95, a death benefit would be paid to his heirs.

Another example: Jack, wanted a PRP for his granddaughter (Sara, age 9) to provide $40,000 ($10,000 per year) for a college education and $50,000 at age 30 as a down payment on a house. The retirement payment starting at age 60 was projected to be $137,653 per year.

A computer model told us Grandpa Jack's plan could be implemented for an annual premium of just $10,000 for six years. A total investment of only $60,000 will not only get Sara started in life, but will take care of her retirement. Amazing!

A PRP works well as long as the person receiving the benefits is about age 45 or younger.