Case Study: The Power of Tax-Free Compounding

April, 2024
Case Study: The Power of Tax-Free Compounding

One of the basics of finance that is commonly used to help demonstrate the power of saving and investing, and doing so at an early age, is the power of compounding interest.  Compounding interest is when interest is applied not only to a principal amount, but also to the interest that has already accrued on that principal, making the total grow faster.

Today, we want to talk about a private placement life insurance (“PPLI”) version of this concept – the power of tax-free compounding.  

Many affluent investors have portfolios that include alternative investments, such as private credit or hedge funds.  If these investments pay a current yield or if the investor has taxable assets invested with a manager who actively trades, there could be tax consequences.  Those taxes reduce the total amount of the investment and, in certain high-tax states such as California and New York, might do so in a sizeable way.

With a properly structured PPLI, this same investment strategy can be deployed in a more tax-efficient manner due to the tax deferral available with the PPLI.  This keeps more capital actively deployed and to growing.   Bonus, no K-1s!

Let’s explore an example of what tax-free growth might look like.

Meet Laura.  She is 50 and divorced.  Her current net worth is $60 million, and she has an annual income of $500,000.  Her liquid portfolio investments stand at $30 million.  

Laura would like to reduce the income taxes upon the earnings from her liquid portfolio assets and grow them on a tax-deferred basis. Additionally, she is looking to reduce the potential estate tax that will be due upon her death.  She speaks to her team of financial, tax and legal advisors and they suggest the following solution.

Using her remaining lifetime federal estate and gift tax exemption, Laura transfers $10 million of liquid portfolio assets into a Grantor Trust Irrevocable Life Insurance Trust (“ILIT”).  Over the course of 4 years, the ILIT pays a premium of $2.5 million per year for a PPLI policy issued by Investors Preferred.  Laura chooses that the policy premiums be invested via a separately managed account (a “SMA”).  Her registered RIA is hired by Investors Preferred to manage the segregated policy account pursuant to an agreed upon Investment Policy Statement.

Under this structure, the policy SMA grows and accumulates tax free.  Laura has the ability to take distributions (potentially on a tax-free basis) from the policy proceeds.  At her death, the death benefit from the policy will be paid to her beneficiaries income-tax free and that amount will be significantly larger than if she had left the original $10 million in a taxable account

These numbers tell the story and demonstrate the power of this form of compounding:

Case study Figure One

Assumptions:  50-year-old healthy female.  $2.5 million annually for 4 years.  7% net rate of return.  25% ordinary tax rate.  Low load.  No surrender charge.

Please see our full disclosures here.

For financial advisor use only. This material is based upon information generally available to the public and from third party sources believed to be reliable. Investors Preferred does not independently verify any of the information it receives. Investors Preferred gives no representations or warranties as to the accuracy of such information and accepts no responsibility or liability (including for indirect, consequential, or incidental damages) for any error, omission, or inaccuracy in such information and for results obtained from its use. Information is as of the date indicated and is subject to change without notice. This material is intended for informational purposes only and should not be construed as legal, accounting, tax, investment, or other professional advice. These materials should only be considered current as of the date of publication without regard to the date on which an individual may receive or access the information.

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