To Save Taxes on Alternative Investments, Pay Attention to Packaging

The potential for outsized returns has many investors turning to “alternative” strategies amid the dimming prospects for traditional asset classes. The allure is understandable, given the modest projected returns for municipals bonds and global stocks over the next ten years. But as with all investment choices, there are trade-offs. In this case, returns from many alternative investments are taxed as current income at the highest marginal tax rate—which materially detracts from their return potential.

Fortunately, with the right structure, high earners can improve after-tax returns of tax-inefficient alternative investments. For instance, private placement life insurance (PPLI) and private placement variable annuities (PPVA) allow purchasers to direct their premium payments into a wide range of non-traditional investment options. Essentially, paying attention to packaging has become more important than ever.

It’s What’s Inside That Counts

For most, PPLI and PPVA aren’t obvious choices. More commonly, investors concentrate high-returning, tax-inefficient alternative investments—like hedge funds or direct lending—in tax-deferred qualified retirement plans or individual retirement vehicles. But many of these accounts lack adequate capacity to take full advantage of their tax-deferred nature. Plus, the less liquid profile of alternative investments tends to create complications when required minimum distributions kick in.

A more elegant solution? Qualifying investors can package high-returning, tax-inefficient investments in a portfolio that’s accessed through a low-cost PPLI policy or PPVA contract. When properly structured, the growth of assets won’t be subject to current income taxation. And, if the PPLI policy is held until the insured’s death, the beneficiary generally receives the proceeds income tax–free. That’s not the case with PPVA, though. Instead, the death benefit (above the contract’s cost basis) is subject to income taxes at the highest (ordinary) rates when distributed to a beneficiary other than a qualifying charity.

How Do They Compare?

Unlike typical insurance products, PPLI and PPVA are offered to accredited investors and qualified purchasers privately—rather than to the public through a formal securities registration. Here’s a quick overview of how the two strategies compare.

Comparing Options

An Exclusive Arrangement

Why not just use “normal” life insurance or annuities? Retail-variable life insurance and annuity products generally provide access only to registered funds. In contrast, PPLI and PPVA can offer unregistered funds, potentially including high-returning, but tax-inefficient, alternative investment strategies.

Plus, expenses associated with traditional life insurance and annuity products may be much steeper. The combination of higher expected returns and lower expenses makes PPLI and PPVA particularly appealing—especially in today’s environment. Because they’re treated as unregistered “private placement” investments for securities law purposes, only qualified purchasers and accredited investors may purchase a contract.1 That allows insurance carriers to customize the investment options available within the policy to meet the needs of prospective investors.

Who’s in Control?

PPLI and PPVA differ from traditional insurance contracts in other important ways. For instance, to meet IRS guidelines,2 PPLI policyholders or PPVA contract owners must give up investment control over the assets. If the owner maintains too much control under applicable tax laws, the policy or contract will be nullified, and all income tax benefits will be erased.

To help mitigate this risk, investors should choose an experienced investment manager with established investor control protocols. Often, a menu of pre-set investment options will be made available, in the form of commingled funds already approved on the insurance carrier’s platform. Some insurance carriers also offer separately managed accounts. Either way, the owner should be able to select from among curated strategies and objectives while being prohibited from directing individual holdings within a given strategy or mandate.

Quantifying the Opportunity

By offering different packaging, PPLI and PPVA can enhance alternatives’ tax efficiency and return potential. Consider an alternative investment producing a 10% pretax annual return. When taxed as ordinary income at an effective tax rate of 40.8%, the gain quickly falls below 6% after-tax. And adding in state and local taxes—where the blended rate could exceed 50% in some jurisdictions—could further reduce the after-tax return to less than 5%.

In contrast, the investor could forego current income tax by holding this alternative strategy in a properly structured PPVA contract or PPLI policy. The investment portfolio would bear annual contract or policy expenses. But, if efficiently structured, those expenses would add up to significantly less than 1% of cash value annually over the long term.

For instance, let’s assume that same alternative investment is held in a PPLI policy with an annual insurance expense of 0.70%. Now, the strategy’s 10% pretax annual return becomes 9.3% after expenses. Yet if the PPLI policy is held until the insured’s death, that 9.3% tax-deferred return becomes a 9.3% after-tax return—a figure that’s nearly double the 5% gain when held outright (since the PPLI death benefit is not generally subject to income taxes).

What if the investor held a PPVA contract instead? Income taxes on the beneficiary’s deferred earnings would reduce the after-tax return to 6.3% over 20 years and 7.0% after 30 years. In other words, after fees, the PPVA still improved the annual after-tax return by 1.3% over two decades and 2% after three. While that may seem modest, this translates to an additional $770,000 of wealth per $1 million initially invested over 20 years or $3.2 million per $1 million over 30 years (Display). 

Even Seemingly Modest Tax Savings Can Greatly Enhance Wealth

Simplified Reporting

With PPLI and PPVA, investors also benefit from simplified tax reporting for alternative investments. Often structured as limited partnerships, alternative strategies must issue a Schedule K-1 each year to its limited partners. This often forces investors to extend their personal income tax returns as they wait for the partnership to issue the K-1s.

The inclusion of even a single K-1 can significantly increase the complexity and time required by a tax preparer to complete the investor’s personal tax return. In contrast, if the partnership is held through a PPLI policy or PPVA contract, there is no current income and no tax filing requirement for the investor. That means no K-1s, state tax filings, or need for an extended tax return.   

Ring it Up

As high-income individuals and families tend to guard against a bigger tax bite, so improving the after-tax profile of their alternative investments makes sense—even if tax rates stay where they are today. Finding better ways to package high-returning, tax-inefficient investments—through a low-cost PPLI policy or PPVA contract—will remain a priority. 

Robert Dietz, CFA
National Director, Tax Research—Investment & Wealth Strategies
Thomas Pauloski
Senior National Director, Institute for Trust and Estate Planning—Wealth Strategies Group

1 An individual generally qualifies as an accredited investor if (1) such person’s individual net worth, or joint net worth with such person’s spouse, exceeds $1,000,000, or (2) for each of the two most recent years, such person’s individual income exceeds $200,000, or joint income with such person’s spouse exceeds $300,000. See Rule 501(a) of Regulation D under the Securities Act of 1933. An individual generally qualifies as a “qualified purchaser” if he/she owns no less than $5 million in investments. See Section 2(a)(51)(A) of the Investment Company Act of 1940.

2 See Rev. Rul. 82-54.

The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.

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