VULI

VARIABLE UNIVERSAL LIFE INSURANCE
By Nathaniel E. Clement, J.D.
Everyone knows about two popular financial accumulation techniques: (1) IRAs 
/&nbsp; qualified retirement plans (the term "qualified plans" includes 401(k) plans, 403(b) plans, profit sharing plans, thrift plans, and pension plans) and (2) variable annuity contracts. The subject of this memorandum is a third accumulation device, which I think is better than either of the above two (as good as they 
may be). The vehicle I am referring to is the variable universal contract. The reason I like the variable universal contract is because it can give the investor both tax-free accumulation and tax-free distributions, free of both the income tax and the estate tax.
IRAs, qualified plans, and variable annuity contracts are often referred to by financial advisors as "retirement plans" and, indeed, these techniques do accumulate wealth very well because they grow on a tax-deferred basis - you only pay tax when you take money out. Also, contributions to qualified plans are often matched by the employer.
On the other hand, the advantages of IRAs, qualified plans, and variable annuity contracts come with a cost: (1) Money withdrawn is, with some exceptions, taxable at ordinary income tax rates; (2) money withdrawn before age 59 carries a 10% penalty; and (3) the balance in these accounts is subject to income taxes when the owner dies (this tax is called the "IRD" tax). Additionally, the balance in these accounts is subject to the estate tax when the owner dies. 
Often people that I work with tell me they want to achieve financial security and preserve the family's wealth from taxes - all taxes. Accumulating too much wealth through IRAs, qualified plans, and variable annuity contracts will not allow this.
A new financial product has come available in the last decade that is only now being understood by attorneys, financial advisors and consumers. This product is the variable universal contract. 
To explain a variable universal contract (which I will refer to for brevity as "VUC"), it is best to first explain its similarity to a variable annuity contract. A variable annuity contract (sometimes called simply a "variable annuity") is a financial device that most of the investing public is familiar with. It is a very popular investment device. A variable annuity can be issued only by a life insurance company. Funds in a variable annuity are invested in a package of funds called "sub-accounts" (which are similar to mutual funds) from which the investor selects. No income tax deduction is obtained when one invests in a variable annuity contract. But, once invested, all growth in the annuity (including dividends) occurs tax-deferred. The term "tax-deferred" means the funds in the annuity are eventually taxed; this will occur when the investor takes money out of the annuity contract. Money taken out of a variable annuity in excess of basis is taxed as ordinary income (not capital gain). Annuity contracts name a beneficiary; this means when the owner of the contract dies, distribution is made to the beneficiary. The beneficiary will be taxed at ordinary income tax rates on the distribution. Additionally, the balance in the annuity contract is part of the taxable estate of the owner, so the decedent's estate must pay an estate tax on the then-existing market value of the variable annuity. Unfortunately, this means the annuity is subject to double taxation.&nbsp; The total taxes paid can easily amount to 75% or higher. To recap: Annuity contract attributes are: (1) no income tax deduction up front, (2) tax-deferred growth during life, (3) withdrawals during lifetime taxed as ordinary income, (4) income taxation at death at ordinary income tax rates, and (5) estate taxation at death.
Annuity contracts have an additional attribute: Annuity contracts carry a death benefit (an insurance policy). This is mandatory and comes with all annuity contracts. Indeed, without this feature, which makes an annuity a life insurance product, the accumulation in the annuity would not be tax deferred. The death benefit varies with the particular insurance company that issues the contract, but the death benefit usually works like this: If the annuity's fair market value is at least equal to what was invested, the insurance benefit is zero; but if the owner's cost in the annuity contract is greater than the fair market value of the annuity when he or she dies, the insurance benefit is equal to the difference required to bring the annuity value up to cost basis. The insurance feature obviously is a cost that is built into the annuity contract, which must be paid out of the money that is invested in the contract. On the other hand, were it not for the insurance feature, the annuity contract would not have its tax-deferred attribute. The insurance feature means the annuity owner will always get back at least his or her investment in the annuity; this is useful to investors who are greatly concerned about down markets at the time of death.
Next, let's discuss the tax attributes of IRAs and qualified plans. These plans work exactly like variable annuity contracts, except the owner/employee gets an income tax deduction on money contributed to the plan. Also, often an employee's contribution may be matched by the employer - and the match is not taxed to the employee (a valuable benefit). All funds taken out of an IRA or qualified plan, are, however, totally taxable at ordinary income tax rates, not capital gains rates.&nbsp; At death, the beneficiary of the plan must pay income tax, again at ordinary income tax rates, on the full amount received; also, the estate of the owner must pay estate taxes on the balance in the plan. Thus, like annuity contracts, there is double taxation. 
Note that the law puts a limit on how much an owner can contribute to one of these plans. It's also important to note that no life insurance can be purchased in IRA accounts, and only in rare cases in qualified plans.
Now, let's move to the subject of this article, the variable universal contract (VUC): (1) As with an annuity contract, the owner gets no income tax deduction when contributions are made to a VUC (unlike IRAs and qualified plans), but: (2) unlike annuity contracts, IRAs and qualified plans, the owner's withdrawals from a VUC are tax-free up to basis and thereafter are taxable as ordinary income; and: (3) unlike annuity contracts, IRAs and qualified plans, the owner can pass a VUC to beneficiaries totally tax free - free of any income taxes and free of any estate taxes. 
Like an annuity contract (and unlike IRAs or qualified plans), the variable universal contract must carry a death benefit (an insurance policy). This is because VUCs, like annuity contracts, can be issued only by life insurance companies. Like variable annuity contracts, investments in a VUC are made in mutual fund-like accounts.
It's important to note that the life insurance element of a VUC is much more substantial and more real than that associated with an annuity contract. With a VUC, the death benefit for the beneficiary can be structured in one of two general ways (with variations): (1) The death benefit can be the greater of some stated death benefit or the accumulated investments in the VUC, or (2) the death benefit can be a stated death benefit plus the accumulated investments in the plan. What is best in any one case depends on planning objectives. Thus, the death benefit options mean that a VUC can be structured (1) to emphasize the death benefit component, or (2) to de-emphasize the death benefit component. The second option, when used, will result in more funds being allocated to the investment account in the VUC and less funds being used to purchase death benefits - this will be appropriate in those cases where the owner wants to maximize his or her ability to use the funds during life for living expenses. Because the death benefit with a VUC is generally much more substantial than with an annuity contract, VUC contracts are referred to as "variable universal life insurance contracts."
Distributions from VUCs during the owner's life are tax-free up to basis. Distributions after the owner's or insured's death are not subject to income taxes, but are subject to estate taxes - unless a trust or a third party owns the contract. What this means is that a VUC can easily be structured to avoid both income taxes and estate taxes. This is not possible with annuity contracts, IRAs or qualified plans, unless the funds are given to a charity at death. VUCs do not require charities to avoid the estate tax.
Some of the most popularly asked questions about VUCs are as follows:
Do I get an income tax deduction when purchasing a VUC? No. 
Can I withdraw money from a VUC during my lifetime? Yes - and, unlike a variable annuity contract or an IRA or qualified plan there is no pre-59 penalty on such withdrawals. 
If I withdraw cash during my lifetime from a VUC, is it taxable? No - withdrawals up to your basis are not taxable. Withdrawals beyond basis are taxable unless you borrow such amounts, in which case they are not taxable. Usually, the interest rate on such borrowings is approximately offset by the earnings rate credited by the insurance company on the amount borrowed, which means that the loans are usually close to zero-cost. 
Explain what you mean by a trust owning the VUC? A VUC is quite viable without a trust. But a trust as the owner instead of an individual owner will add estate tax benefits and can add creditor protection to the VUC. This trust must be an irrevocable trust which is specially designed for a VUC and designed to give the trustmaker maximum benefits during his or her lifetime where lifetime access to the investment account is important. A properly designed trust will allow tax-free benefits from the VUC during the trustmaker's lifetime - and will protect the funds in the VUC from the estate tax when the trustmaker dies. A VUC owned in a trust, properly structured and properly administered, means no income taxes and no estate taxes. Please note that merely designing the trust properly is not enough - the trust must be administered properly during the trustmaker's lifetime. 
Can I pass on at death the balance in my VUC (including the death benefit) to my children free of taxes? Yes, there is no income tax. And, unlike annuity contracts, IRAs and qualified plans, there is no estate tax if you own the VUC in a trust. 
Why can't I own my qualified plan, my IRA, or my variable annuity contract in an irrevocable trust? You could but it would be a tax disaster. If you put IRAs, qualified plans, or variable annuity contracts in an irrevocable trust, it is a taxable event and the whole amount becomes taxable. Only VUCs can be owned in an irrevocable trust. In some cases, an irrevocable trust can own an annuity, but the annuity is still subject to both income taxes and estate taxes. 
Can a VUC be a substitute for money I am putting in a qualified retirement plan at work? Yes. If your contribution to a qualified plan is being matched by your employer, however, I advise that you continue to contribute to the plan up to the maximum the employer will match. Your money beyond the "match" is, however, a good candidate for investment in a VUC. Remember that contributions to an IRA or a qualified plan are tax-deductible; that is not the case with a VUC. But once the money is invested in a VUC, the money grows tax-free just as it would in an IRA or qualified plan. The money can grow without limit and to any amount - and all of it can be tax-free when it comes out, during lifetime or after death. 
Is the death benefit of VUCs taxable? No - at least there is no income tax. If the contract is owned in a properly structured trust and administered properly, the death benefit will also avoid the estate tax. Similarly, if a VUC is owned by a third party, such as a child (or children), it will not be subject to estate taxes when the insured dies.
Are there advantages in children owning a VUC (with a parent the insured party) instead of a trust? The up-front cost saving of not paying for a trust is the only advantage. The disadvantages of children as the owner are many: If the children own it, you have no control over the contract, as you would with a trust. If the children own it, you can't get distributions from it during your lifetime unless the children give it to you, and even then it will be a taxable gift from them to you. Also, if a child gets divorced, the contract may be lost in a marital settlement. Also, if a child does not make a premium payment in time, the contract might fail. Will a child have the money to make the annual premium (cash contribution) payment? 
If a trust owns the VUC, all of the potential problems are avoided. With a trust, the trustee that you select will be a sophisticated party that will make sure the contract stays current and all premiums (contributions) are paid as required; the trustee will make sure that the cash value (investment account) is properly invested and remains at a proper level. The trustee may consult with you informally about investment strategy and you can even retain the right to remove and replace the trustee. The money to pay the premiums will come from you, which you give to the trustee annually. You and the attorney write the terms of the trust to meet your planning goals, which may or may not include access to the cash value during your lifetime, and your directions as to what happens to the balance at your death. A trust lets you control the funds as precisely as you wish, even in perpetuity in a dynasty trust arrangement.
How does a trust acquire ownership of the VUC? You set up the trust first and the trust purchases the VUC - not you. 
How can I withdraw funds from the VUC if an irrevocable trust owns the VUC? By several methods which are designed in the drafting of the trust. For example, the trustee can be given a "limited power to appoint." Or, the law of some states allows a trust to be formed that will actually name the trustmaker as a direct beneficiary and still not have the proceeds of the trust includible in his or her estate. Another way is to allow the trustee to loan funds of the trust to you. So, there are many different ways to access money.
If I can have access to the funds in the trust, how does the irrevocable trust keep the funds from being taxed as part of my estate? Just because you can be "user" of the funds in the trust does not mean you become the "owner" of the trust for estate tax purposes. (This is a critical distinction and is used frequently in estate planning when a married couple sets up a "family" trust in their estate plans - a family trust is the trust which allows the surviving spouse to be a user of trust property but not the owner.) If an IRS audit determines that the trustmaker intended to get regular distributions from the trust, then the proceeds may be includible in your estate. This is why I say that how the trust is established and administered during the lifetime of the trustmaker is very, very important.
How does the trust get the money to invest in the VUC? The maker of the trust (trustmaker) makes gifts of money to the trust. The trustee of the trust then uses the money to purchase a VUC. The gifts to the trust are potentially subject to the gift tax, so it's best to "cover" the gifts to the trust to the fullest extent possible with the $12,000 annual exclusion. 
What's the $12,000 annual exclusion? This is the amount that the U.S. government (as well as the State of N.C.) allows you to give away each year to as many donees as you wish. For example, if you are married and you have two children, you can give $24,000 to a trust with no gift tax. With a technique called "gift-splitting" you can give another $24,000 to the trust on behalf of your spouse, again with no gift tax. That's a total of $48,000 that could be contributed in this case tax-free each year to the trust which owns the VUC.
What if my spouse does not have $22,000 in her name that could be gifted to the trust? &nbsp;Not a problem if YOU can contribute for her.&nbsp; If only one spouse has the money, then that spouse can borrow the other spouse's right to make annual exclusion gifts.
Can I take money out of my IRA and put it in a VUC? Yes, and I sometimes recommend this. You will have to pay income taxes on such amounts withdrawn from the IRA or qualified plan; but once contributed to the VUC, the money grows tax-free and can be taken out tax-free. If you die before appreciable accumulation takes place, there could be a sizable death benefit, again tax-free.
I have an IRA and I am not going to need it for retirement. Is there a way I can get this money into a VUC? Yes. The first way is described above - you can simply take a distribution from the IRA, pay the income tax, and then contribute the amount left after taxes to the VUC. While this procedure will enhance family wealth, many people detest paying the income tax on the withdrawals from the IRA. For such people, another technique is available, which is appropriate only for IRAs of over $1 million. This technique does not result in having to pay income tax on the IRA. This way entails setting up an LLC, a trust, and a split-dollar agreement between the two. This method is highly technical and beyond the scope of this article, but the end result is IRA money is used to purchase a VUC without paying income tax on the IRA dollars. 
Will I have more choices if I invest in a portfolio of stocks and other securities vs a VUC or an annuity? Yes. Investment options in a VUC and an annuity are limited to a selection of funds that go with the contract. The funds are varied, however, and allow you (or your trustee) to diversify your portfolio by selecting asset classes.
Can a variable universal contract be a substitute for a whole life insurance policy? Yes. The cost of insurance should end up being cheaper with a VUC contract than with a whole life insurance policy, which, in turn, will allow more of the money to go into the cash value (investment) account. VUCs can invest in equities (held in separate accounts that resemble mutual funds), whereas the investments behind a whole life insurance policy are government and high-grade corporate bonds. Over time, equities will yield more than bonds, and for this reason, over a ten year period, a VUC should virtually always produce more "cash value" than will a whole life contract.
I'm not interested in accessing the investment account during my life, but a death benefit when I die is what is important. Is a VUC a safer way to accomplish this than a whole life insurance policy? It depends on the time frame. Equity investments fluctuate more than bond investments. It is possible that at any one point in time, a severe market correction could make a portfolio of equities worth less than a portfolio of bonds. On the other hand, over time equity portfolios grow much more than bond portfolios. Because bonds fluctuate less than equities, insurance companies are usually willing to issue better guarantees with whole life policies than with VUCs. The price for this guarantee, however, is a higher cost for the insurance. 
What happens if I invest through a VUC and allow the death benefit to lapse? This would be a mistake, since the tax-free death benefit is a major reason that a VUC is such a good substitute retirement plan. Also, a lapse of the death benefit or a surrender of the contract during your life will mean tax on amounts received in excess of basis (total amount paid in).
Can the life insurance component (the death benefit) of the VUC be on one life or two lives? It can be on one life or two lives. If the VUC is a retirement plan substitute, the death benefit will typically be on only one life - usually, but not always - the husband. If the primary reason for the VUC is to replace wealth that is lost to estate taxes or that is given to charity, then for married couples a "second-to-die" contract will be the investment of choice.
I do not have to pass a medical exam when I purchase a variable annuity contract - is a medical exam required for a variable universal contract? Yes. This is because the insurance component of VUC is more substantial and often quite substantial.
How useful is the VUC in dynasty trust planning? Life insurance is the preferred investment vehicle for dynasty trust planning. This is because the "generation-skipping transfer tax" exemption is $2.0 million this year. When engaging in "GST tax-avoidance" planning, you typically want every dollar of the ar GST tax exemption to count. Life insurance affords leverage for that purpose ...it allows a million dollars of premium contributions to insulate perhaps many millions from the GST tax.
Is there anything else I should know about VUCs? Yes, they are sophisticated financial products; you should deal only with financial professionals who understand the products or who are willing to bring in experts to design exactly the right product for you. No investment guarantees come with investment products, so the product should be conservatively structured to avoid disappointment if investment projections do not meet actual long-term investment performance. With VUCs I cannot emphasize enough the importance of working only with seasoned and experienced financial professionals.
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Copyright, Nathaniel E. Clement, 
Counsellor at Law, 2007
1709 Legion Rd., Ste 214, Chapel 
Hill, NC 27517
Tele: 919-929-9298
THIS ARTICLE MAY BE PHOTOCOPIED AND DISTRIBUTED IF COPIED IN WHOLE WITHOUT ALTERATIONS.
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