Life insurance agents often talk about internal return (IRR) when discussing life insurance with cash value. The term may seem exotic, but expressed in simpler terms, it is the return you achieve on the premiums that you pay into the insurance. Equipped with this information, we can compare how it works to put money into a full life insurance or a universal life insurance with a variety of other options you have available to you.
Personally, I have always found the internal return discussion stupid. Some customers ̵1; mainly those who work in finance – ask about it. And because insurance programs can calculate it, it makes life easier compared to calculating it yourself. But for most people, the return is generally an esoteric notion.
Few people can tell me what it means for them to have a certain return. However, there are many people who believe that it is always better to just have a higher return. There are a number of circumstances in which I agree. But the pursuit of wealth accumulation, retirement planning, and other financial planning-related topics can be more nuanced than just “giving me the highest return you can.”
With that said, insurance agents – who want to sell life insurance policies – know that people often rank returns high in terms of importance. So all massages can do to … “improve?“Yield interest (ie internal rate of return) is a sure way to convince more people that they should buy more life insurance. Right?
Taxable corresponding return
Life insurance with cash value (eg full life insurance and universal life insurance) enjoys many tax benefits. The foremost among these benefits is to accumulate and distribute completely income tax-free cash value (when done specifically / correctly).
Given the tax-free nature of life insurance cash value, many agents claim that it is an incomplete story to simply compare the life insurance cash value with the accumulated value of many other savings / investment options. We can not compare any alternative that does not avoid tax liability as life insurance – and there are very few alternatives that avoid taxes as life insurance – because we will overestimate the benefit from the taxable alternatives and / or underestimate the benefits received from life insurance.
So to adjust for this complexity, several life insurance companies began to include the internal interest rates for return calculations that included an adjustment for income tax liability. The agent simply connects the potential buyer’s tax rate, and now we know how much extra return he / she needs on other accounts to achieve the same cash value projected from the life insurance. Easy, and definitely not susceptible to any tampering that may exaggerate the required return to match a life insurance policy – sarcasm lamp lit and glowing red hot.
What is your tax rate?
I have been selling life insurance for more than a decade now, and during that time I have seen many proposals presented by various agents. Within these proposals, I have seen many internal return reports that include this taxable corresponding adjustment. What is interesting about all of them is the tax rate they adopt. Many of them are north of 50%.
Now I’m not here to say that taxes are too low and need to be raised – I just reluctantly cut two large checks today myself. But if one assumes an effective tax rate of 50%? Shouldn’t we just question it a little bit?
Average effective tax rate that Americans pay
Most of us are at least somewhat familiar with US tax law regarding income and its progressive nature. As your income rises, you may eventually cross a threshold that exposes you to a higher tax rate on a certain the amount of your income.
For example, if you happen to have an income that places you in the tax class 37% – which happens to be the highest class at the moment – it means that certain of your money is subject to a tax rate of 37%. However, that does NOT mean that ALL of your money is subject to 37%. So being in the 37% tax bracket does not mean you are paying 37% in taxes. In fact, very few Americans pay anything close to 37% of their income in taxes.
According to IRS data compiled by TaxFoundation.org, the top 1% of income taxpayers in the US paid an average effective income tax rate of only 25.6% in 2019 – it has actually decreased slightly since then, but this was the most complete compilation of data, so that is why I quote it.
Note that none of the other cohorts has an effective tax rate above 20%. It is worth noting that this information does not include state income taxes or FICA. Adding these will certainly increase the effective tax rates paid, but we are still far from 50%.
Unreasonable assumptions make us look stupid
Many people lie with statistics – a good book was written on the subject several years ago. But using wildly inflated tax assumptions to make life insurance returns look better hurts us as an industry more than it does to contribute to more sales.
Few people know what their effective tax rate is, I have no doubt about that. But I think most people can reasonably pick out that they do not give up 50% of their income to tax. They may hate to pay them – most everyone does. This does not mean that they willingly accept the idea that half of their income goes to taxes.
As professionals – some of us shop stewards with good-looking certifications – we need to approach modeling savings and investment options with care to help our clients make the right decisions. Carelessness reflects badly on our industry.