Private placement life insurance

In short

A friend of mine sold his company last spring and asked me what to do with the check. He did not want a sales pitch. He wanted to know how the thing works. Private placement life insurance, often called PPLI, is a life insurance policy built for wealthy buyers, where the owner picks the investments inside the policy instead of choosing from a fixed menu. The idea is that growth inside a life insurance contract can build up without yearly income tax, and a death benefit can pass to heirs free of income tax. If you are weighing it, start by learning whether you qualify, since the law sets income and asset tests for buyers. Next, find out what the policy costs in fees and premium taxes, and how the law limits what the investments may look like. Then hire a tax lawyer and an independent actuary who answer to you, not to the seller. Slow down. This is a big step.

The whole of it

What it is

I once watched a neighbor buy a tractor without ever asking what it cost to run. He loved the machine and forgot the diesel. Private placement life insurance deserves a better look than that. It is a life insurance contract sold privately, not to the public, and the owner funds it with large premiums over a few years. The money goes into separate accounts, which are pools of investments held apart from the insurer's own funds. The owner, with an adviser, directs what those accounts hold, within limits.

Federal tax law treats a contract as life insurance only if it passes certain tests, and those tests live in Section 7702 of the Internal Revenue Code. A second rule, Section 817(h), says the investments in a variable policy must be spread out enough. A third idea, called investor control, comes from Internal Revenue Service rulings. If the owner holds too much say over specific investments, the tax office may treat the owner as holding those assets directly, and then the tax benefit is gone. So the policy has a leash on it, and the leash matters.

Buyers have to be what the securities laws call accredited investors and qualified purchasers. Those terms set income and asset tests, and the Securities and Exchange Commission explains them on its website. The seller must confirm the buyer qualifies before the sale goes through.

How it works

If you have ever paid a big tax bill on investment gains, you know the sting. A policy like this changes when and whether that tax lands. The owner pays premiums into the policy. The insurer takes out charges and then places the rest in the separate accounts. Gains inside the policy are not taxed to the owner each year. The owner may later take money out through withdrawals up to the amount paid in, or through policy loans. Loans are not income when taken, but the contract has to stay in force or the loan can turn into taxable gain.

At death, the insurer pays the death benefit to the beneficiaries. Under Section 101 of the Internal Revenue Code, that payout is generally free of income tax. Estate tax is a different matter. If the owner holds the policy in his own name, the death benefit can count in his estate. Many families place the policy in an irrevocable trust to address that, but the trust brings its own rules, costs, and loss of control.

Some policies are offered offshore, and some by insurers in the United States. The seller must follow the tax and securities rules that apply, and the policy owner has duties too. Foreign reporting forms may apply, and the Internal Revenue Service describes them on its site.

The numbers, and where to find yours

You have probably noticed that the glossy brochure leaves out the price. Ask for it in writing. A policy of this kind carries several charges. There is usually a premium tax, which is a state or federal levy the insurer pays and passes along. The IRS also taxes the insurer through what is called a DAC tax, and sellers often pass that on as well. There are fees for the cost of insurance, which is the charge for the death benefit itself. There are asset based charges for administration, and there are the fees of the investment managers inside the accounts. Each piece comes out of your return.

The income and asset thresholds for buyers are set by securities rules, so check the current figures on the SEC page for accredited investors and for qualified purchasers. The federal estate tax exemption changes by year, so use the current figure, which the official source publishes each year and confirm it at the IRS estate tax page. The gift tax annual exclusion, which matters when a trust pays the premiums, is the current figure, which the official source publishes each year. The tax rate on long term gains outside a policy, which is the rate you would otherwise pay, is the current figure, which the official source publishes each year. Pull your own tax return and your own brokerage statements. They show what you pay today, and that is the number the policy has to beat.

A worked example

Let me tell you about a founder I will call Dana Whitfield. She sold her firm and has $4,000,000 she does not need for twenty years. Her investments earn 7 percent a year before any tax. Outside a policy, suppose she loses 1.5 percentage points of that each year to tax. Her after tax return is 5.5 percent.

Now picture the same $4,000,000 in a policy. Say total charges run 1 percent of the account a year, with a 1.0 percent drag. Her return after charges is 6 percent. Each year she is not paying tax on the gains.

Here is the math at year twenty. At 5.5 percent for twenty years, $4,000,000 times 1.055 raised to the twentieth power is $4,000,000 times 2.918, which is about $11,672,000. At 6 percent, $4,000,000 times 1.06 raised to the twentieth power is $4,000,000 times 3.207, which is about $12,828,000. The gap is about $1,156,000, in her favor on paper.

But those figures leave out some things. They leave out the premium tax. If it were 1 percent, that is $4,000,000 times 0.01, or $40,000 up front. They leave out legal and set up costs, and the cost of any trust. If those came to $60,000, her start drops by $100,000. They leave out the chance that the investments inside the policy earn less than she hoped. They also leave out a rule change. Congress can alter how these policies are taxed, and it has changed life insurance rules before. A gap that looks large can shrink fast once real costs go in. Dana would be wise to run the numbers three ways, with a low, middle, and high return, before she signs anything.

Where it goes wrong

I have seen smart people stumble on this, and not because they were careless. The first trap is investor control. If Dana tells the manager which stock to buy, the tax office may say she owns the stock, and the policy loses its shelter. The adviser who picks the investments has to act on his own judgment, not on her orders.

The second trap is the contract falling apart. If too little premium sits in the policy, or the investments sink, the contract may fail the tests and lapse. A lapse with a loan outstanding can create a tax bill. Watch it closely.

The third trap is cost buried in the paperwork. Sellers earn fees, and the person advising you may be paid by the sale. Ask who gets paid, how much, and when. The fourth is law change. Lawmakers have eyed these policies, and a new rule could apply to existing ones. The fifth is liquidity. Money in the policy is not as easy to reach as cash in a bank. And the sixth is the offshore risk, where the insurer sits in another country and the owner may have less protection if the company fails.

Questions to answer before you leave this page

Have you confirmed, in writing, that you meet the accredited investor and qualified purchaser tests that the SEC describes? Do you know every charge, from premium tax to the DAC tax pass through to manager fees, and have you added them into your own worked example? Who is paid if you buy, and did that person show you a case where the policy loses? Does your plan keep you clear of investor control, and has a tax lawyer who works only for you read the contract? Will the policy sit in a trust, and have you weighed the loss of control against the estate tax benefit at the current figure, which the official source publishes each year? What happens to the loan and the death benefit if the contract lapses, and what is your plan if the law changes? And when you imagine your own family reading this contract after you are gone, will they understand it?