There is the “minimum one can pay” for a given amount of insurance coverage for a specific age and the “maximum one can pay”. Who determines the minimum? The Insurance Company. At the other end of the spectrum is the “maximum one can pay” for a given amount of coverage. And who determines that... besides you? The government. The fact that the federal government limits how much money one can put in a life insurance policy says what about it? It must be... good. More specifically, it must be good in relationship to one subject: taxes. Basically the government decided the upper limit of tax advantaged growth they would allow and the policy holder still have access to the cash value. Policies outside this allowable corridor are determined to be a “Modified Endowment Contract” or MEC, which simply means the government will treat the insurance contract like they do “Qualified Plans”, with all the rules, regulations and related penalties. After we're done, you will probably know more about life insurance than most life insurance agents. At a minimum, you will learn something many are not telling you.
There is almost an infinite amount of premiums that can be charged between the “minimum” and “maximum”. As mentioned earlier, the insurance companies determine the “minimum”. They have actuaries that calculate the “least amount of premium” they can charge and still make a profit. They understand “opportunity cost”, which means they have factored in the time value of the premium. In the 1980’s, the government “drew the line” that determined the “maximum” amount of contributions allowable for a given face amount of coverage. They accomplished this with two laws: TAMRA and DEFRA. (Technical And Miscellaneous Revenue Act of 1988) (Deficit Reduction Act of 1984) These two laws basically said “wait just a minute”. The government cannot let people put unlimited contributions in a life insurance policy as was then allowed, because if people did, they may not do what the government was encouraging them to do What does the government encourage you to do besides pay taxes? They encourage putting your money into a “Qualified Plan Account” and defer the taxes. Samples of these accounts include 401(k)’s, IRA’s, SEP’s and 403(b) plans, to name just a few.
What do “Qualified Plans” do? The number one response is that they “defer taxes”. If that is what you said they do, you were only half correct. They also defer the tax calculation. Perhaps a more clear word they could have used would have been postpone. Let’s say you wanted to borrow $10,000. You would ask two questions before you took the money. The first question would be “How much interest do you have to pay?” The second question would be “When do you have to pay it back?” If the lender responded by saying, “We have enough money right now and do not need any payments from you at this time, but there will come a time when we will need the money. When we know how much we need, we will be able to determine how much interest we have to charge to get the amount we need. Would you cash that check? Absolutely not! But this is exactly what we are doing with the government in “Qualified Accounts”. They are not saying “You do not owe the tax”. They are saying “You can pay the tax later”. At what bracket? That is a good question. This is not to say Qualified Plans are bad. However, it is important that you know and understand exactly what they do.
Now, getting back to insurance. Let’s assume you could pay $500 for $500,000 of insurance coverage or you could pay $10,000. Which would you choose? Being bargain shoppers, most of us would probably say $500. “Less is best” when it comes to cost. Right? Let’s say the $500 represents the “lowest premium” one can pay for $500,000 of coverage at a given age. The “lowest premium” is known as term insurance. It provides one benefit, death benefit. Term insurance offers protection for the least expensive initial cost. The best day financially, to own term insurance is which day? If you guessed “the day you die” you were not even close. The best day financially to own a “term life insurance policy” is the first day. That’s right, it is the first day you buy it. Had you purchased the policy today, received approval, signed the delivery receipt, paid the first premium and died on the way home from your agent’s office you cannot get a better return than that financially. To calculate the “rate of return” on such an event would be next to impossible. Granted, it would be hard to get people to sign up for this type of financial windfall.... but you understand the point. If the best day to own a term policy is the first day, it means that for every day you own it, it becomes worth less and less, thus costing you more and more. When determining the cost of “term insurance”, one must also factor in the “opportunity cost” of owning this product. Remember the cost is not just the amount you paid in premiums, but what those dollars “could have earned” had you not bought the coverage and taken the risk yourself - which we are not suggesting you do.
Penn State University completed a study in 1993 on Term Insurance policies where they discovered that: ·More than 90% of all term policies are terminated or converted. 45% within the first year and 72% within the first 3 years. ·Less than 1 policy in 10 survives the period for which it is written. ·After 15 to 20 years of exposure, less than 1% of all term policies are still in force; and ·Only 1% of all term insurance resulted in death claims What does this mean? It means with “term insurance” you will most likely pay more than you receive.
For an insurance company to talk you into putting $10,000 in a policy with an initial value at death that you could get for $500, they would have to come up with some serious benefits agreed? Let’s forget about insurance for just a minute and talk about benefits. In any vehicle one would use to accumulate money over time, a major desire would be to maximize benefits in addition to achieving an acceptable “rate of return”. If you could waive a magic wand. what benefits would you desire? Would you like the money in the account to grow “tax deferred” as opposed to “taxable”? Would you want “tax-free” distributions? Would you want a competitive Rate of Return? You would want to be able to make large contributions? Would you like additional benefits like self-completion, disability protection, and protection from creditors? You would want it to provide collateral opportunities? You would want the money to be safe? Would you want no loss provisions? Meaning you can’t lose it. Would you want guaranteed loan options so you can’t be denied access to your money? How about unstructured loan payments - where you determine the payment schedule? You would want liquidity, use and control of your money. Would want your contributions to be deductible? You would want the maximum amount of benefits possible? Which of these benefits do you get from a Qualified Plan? Tax Deferred, Competitive Return Potential, and Deductible. There is only one product that offers the majority of the benefits on the list and it is “permanent life insurance”. However, not just any type of contract will do. Life insurance policies that are “minimally funded” only provide minimum levels of benefit. Remember the government “drew the line” that determined the “maximum” amount of contributions allowable for a given face amount of coverage. Contributions over this line create a Modified Endowment Contract or “MEC”. However, contributions made right up to this line create a different type of “MEC” that we call the Maximum Efficient Contract. “Permanent life insurance contracts” offer all the benefits listed earlier except that the contributions to a “life insurance contract outside of a Qualified Plan” are not deductible. You may be surprised to learn that there is little to no difference between deductible and non-deductible contributions. In fact, “Tax deductible contributions” that grow “tax deferred” and come out “taxable” are exactly the same as “after tax contributions” that grow “tax deferred” and come out “tax free” assuming the same tax brackets and investment interest rate. What you need to understand is that as you move from the highest possible premium to the lowest, the value of the benefits decrease. The higher the premium, the higher the level of each benefit received, until you reach the MEC line. Up to that line,but not over, is the position that provides the greatest amount of benefits a life insurance contract has to offer, while still allowing liquidity, use and control of your money. There are circumstances where one needs only death protection and a low, “level premium” is desirable. In this situation, or when coverage is needed for a “short period of time”, “term coverage” may be the best immediate temporary solution. If, however, you are looking for a place to accumulate money that provides the highest level of benefits mentioned at their maximum level, “permanent life insurance” can be a solid choice. Currently we know of no other financial product that offers these same benefits at the same level.
Insurance companies limit the amount of death protection one can purchase, known as the “face amount”, based on: ·present age, ·mortality costs, ·current assets, and ·income.
The government set the MEC guideline to limit the amount of contributions allowable in the form of premium payments that still give the policy holder access to the cash value on a tax favored basis.
How much insurance should you have? Most of us assume this is a needs discussion. This discussion is really about “wants” not “needs”. There is no one wise enough to determine what one needs, since the very thought of “need” represents the least amount. A least analysis approach would be to assume that if one purchased the least amount of coverage and died that amount would be adequate. It would be hard to find anyone, who has been successful at anything, who began by calculating the least they had to do to make it. Life insurance should be considered a “want” product. You decide what you “want” to happen then it can be determined how much coverage it will take to accomplish what you want. Life insurance can provide the immediate funds to guarantee that what you want to happen, will happen in the event of your death.
Make sure your policy will ensure that what you want to happen - WILL happen!