"I just became a partner in a small group practice. My tax person tells me the bump in pay is going to mean a lot higher taxes. I am maxing out my 401(k) but still I got a huge tax bill last year. The agent who sold me my disability insurance policy says I should buy some variable universal life insurance from him because it will save me taxes, but I already have $2 million in term coverage from USAA for my wife and kids. One of my partners thinks VUL is a bad deal. What do you think?"
Since it’s early in your career and you have a family to think about, it makes sense to have life insurance. Based on what I have seen in similar cases, $2 million is a good start but it’s not enough to provide everything your family might need to pay off the house, send kids to college (or private school), and pay ongoing costs of living without you. So I do think you need more coverage, but I do not believe variable universal life insurance is the answer.
As a form of cash value insurance, VUL combines the benefits of life insurance with the features you might find in a mutual fund investment. The word “variable” refers to the fluctuations in the cash value as a result of changes in the value of the investments it holds, while the word “universal” means that premium payments are flexible (like a universal joint is flexible).
I would have named this product “variable flexible life,” or VFL for short, but I figure the “F” might be misinterpreted to stand for “fallacious” since misguided physicians who buy this stuff suffer from the mistaken impression that they will save taxes while making a great investment that will protect their families.
The promise of tax savings is more fiction than fact. Sure, the cash value has potential to grow tax-deferred and the death benefit might be income tax-free, but these benefits are not the same as true, permanent tax savings. Since Congress closed most of the loopholes with the Tax Reform Act of 1986, permanent tax savings have grown increasingly scarce, particularly for medical specialists and other taxpayers in the top brackets.
A VUL policy’s tax deferral feature—arguably the only attribute of any value to an investor—may actually cost physicians more money in both the short and long term.
Under current tax law, long-term capital gains and qualified dividends are taxed at a lower rate than ordinary income, but the gain on complete withdrawals from a VUL policy will be taxed as ordinary income. Given that the top federal tax rate on ordinary income is fully 23 percentage points higher than the capital gains rate, equity-based investments made in a variable universal life product may result in taxes that are twice as high as those paid on gains from investments in an after-tax account (a jointly held mutual fund account, for example).
To be clear, a VUL policy will not save you a dime in taxes but it may cost a fortune in fees. The mutual fund-like “separate account” investment options available inside these policies are laden with costs, including operating expenses for underlying funds, management fees layered on top of that, plus an annual policy fee. “Paying those expenses is like rowing a boat with a hole in it. No matter how fast you row, you’re gonna sink,” says Lawrence Keller, an insurance expert with Physician Financial Services, Woodbury, N.Y.
There’s a huge incentive to push these policies. Since it’s common for agents to receive at least half of the first year’s premium as commission, your $50,000 investment means the agent will walk away with $25,000. Not a bad payday… for him. But when you try to walk away from the policy yourself, you will trip over one last expense that physicians often overlook: the surrender charge. Since the insurance company pays the agent up front, it can only recoup the cost by locking you into the policy or charging you heavily if you pull out before they’re done, which may be 10 or 15 years. “Buying a VUL policy is a lot like buying a new car,” said Mr. Keller. “The day after you buy it, it’s worth less than you paid for it.”
Your partner had it right when he cautioned you against VUL, especially when there are so many other vehicles that might be a better fit for you.
Consider term life insurance. Like auto or homeowner’s coverage, term life is pure insurance without cash value. Term life costs far less than VUL on a dollars-per-thousand basis, so every premium dollar buys you more coverage than it would with VUL. You will send less money to the insurance company and keep more for your family.
What can you do with the money you save?
Look into a Section 529 college savings plan. Contributions grow tax-deferred (just like VUL) but withdrawals from a 529 plan are free from income tax when used for qualified higher education expense. Some states will even give you a break on your state income taxes when you contribute—a real, permanent tax savings. (See “Section 529 plans: The best way for doctors to save for college” in the July 2012 issue of Ophthalmology Business.)
Check out a “back door” Roth IRA contribution. Given the average physician’s income, it’s unlikely that you can make a direct contribution to a Roth IRA, and you probably cannot deduct contributions to a Traditional IRA (not unlike VUL). However, you can still make non-deductible contributions to a Traditional IRA, and your spouse can too. After you have made your contribution, ask your tax advisor if it makes sense to convert your Traditional IRA to a Roth, where those contributions can grow tax-free for retirement, no matter how much Congress amps the pain on taxpayers in the top brackets.
After you have maxed out your 401(k), your IRAs, and your 529 plan, think about investing in low-cost, tax efficient equity index funds or exchange-traded funds (ETFs) from companies like Vanguard, Barclays, or Dimensional Fund Advisors. To keep the balance right (and avoid the dreaded Medicare surtax on unearned income), you might also pick up some tax-free income from a municipal bond fund. Finally, you and your partners might want to adopt a defined benefit retirement plan (a “pension plan”) to soak up excess cash that can grow tax-deferred for the long haul.
Keep an Eye on Your Money
The key to financial security is vigilance. Get curious. Ask questions! Dig for answers … or email your questions to firstname.lastname@example.org so I can do the digging for you. If I use your question in “Eye on your money,” I will send you one of my favorite personal finance books to feed your head and a cool “Eye on your money” coffee mug to satisfy your thirst for answers.
Mr. Utley is president and founder of Physician Family Financial Advisors Inc., which delivers fee-only financial planning and independent investment advice to clients coast-to-coast. Contact him at 541-463-0899 or visit www.physicianfamily.com.