Many people whose net-worth exceeds $1,000,000 have begun to understand the concept of succession capital. In short, this is capital that exceeds what an individual will spend in their lifetime and therefore will be passed on to the people and/or organizations that individual chooses. The owner of this capital functions like a CEO of a corporation where the succession capital itself is the business. In the CEO role, the capital owner must make decisions on how to maximize the value of the underlying assets to insure the most favorable investment returns while minimizing the impact of taxes.
Often these succession capital portfolios contain a mix of investments including income producing assets such as corporate and municipal bonds. If managed properly, the income portion of the portfolio can produce a nice aftertax rate of return. Suppose a portfolio contains a mix of income producing assets valued at $500,000 with an aftertax rate of return of 4.2% or $21,000 per year. In 20-years, the portfolio would grow to $1,138,477 if the portfolio were able to maintain this rate of return and reinvest the earnings for a compound return. The income portfolio realizes an overall return of 228% over the 20-year period.
The asset’s size generally disallows it from being owned in a tax-advantaged manner so the full $1,138,477 is subject to estate tax. Therefore the after-tax value of the succession capital has grown only to $626,162, a return of only 25% over 20-years (1.25% per year on a nominal basis).
Now let’s explore the outcome if that same $21,000 of income generated each year was used to purchase a life insurance policy on the capital’s owner, the CEO if you will. The $21,000 of income from the portfolio would purchase $1,435,000 in permanent life insurance assuming the CEO was a 60-year old male in preferred health living in California. Upon death, the benefit would be paid to the same group of people and/or organizations as the original succession capital portfolio.
The death benefit can be removed from the estate through trust agreements. Therefore, the $1,435,000 is not subject to estate tax preserving the entire death benefit as succession capital. The total premium paid over the same 20-year period would have been $420,000. The death benefit represents a 341% total return over the 20-year period (17.05% per year on a nominal basis).
Not only does the life insurance option funded by an income portfolio substantially outperform the traditional option, the full $1,435,000 is available as succession capital in the first year the strategy is implemented. Further, the proceeds are guaranteed regardless of when death occurs. In contrast, the income portfolio is only worth the value at the time of death less estate taxes (about $286,550 in year one). That’s an additional $1,148,450 being passed as succession capital using life insurance as an asset class funded by an income portfolio.
Caution must be used by those considering this strategy. Several life insurance professionals resort to premium financing using a collateralized loan to leverage the portfolio. This allows an even greater amount of life insurance to be acquired. For example, rather than use the $21,000 to pay the premiums due, you can use the $21,000 to pay the interest on a loan of a greater amount. Now the CEO can purchase double or even triple the death benefit ($2,870,000 – $4,305,000) with a lower impact on the income portfolio.
The less advertised disadvantage to premium financing is that loans are limited in duration and must be paid back either from the death benefit or from the owner’s capital. Further, there is no guarantee that future loans will be available creating both future loan payment and premium obligations. Premium financing should be used with caution and only in cases where the CEO of the succession capital can detail a clear exit strategy that pays off any outstanding loan balance without negatively impacting the overall death benefit received.