Should you buy life insurance in one lump sum?

The short answer is, well, it's complicated. In fact, single-premium whole life, or SPL, may be one of the most overlooked, misunderstood, and hence rarely recommended forms of life insurance available today.

Which is a shame, because it can potentially save your heirs a bundle by passing their inheritance along to them tax-free.

Alternative to Variable Annuities

Back in the 1980s, SPL became a popular investment alternative to variable annuities. Like annuities, SPLs grow tax-deferred, even today. Unlike annuities, you could take withdrawals from your SPL tax-free back then, and the death benefit passed to your heirs free of federal income tax, while annuity beneficiaries assumed the tax position of the deceased.

Its best-of-both-worlds reputation soon led to rumors of widespread abuse.

"What people were allegedly doing was, they would borrow money to take out the policy and then borrow from it to avoid taxes," says Judith Hasenauer of Blazzard & Hasenauer, a Florida firm that advises insurance companies.

In 1988, Congress enacted Section 7702A of the Internal Revenue Code, which effectively closed the tax-dodge loophole by classifying SPL as a modified endowment contract, or MEC. 

As a result, withdrawals from SPL policies are taxed as ordinary income, the same as annuities

Once rumors spread that SPL had "lost its tax status," investors and financial advisers alike turned their backs on single-premium life as an investment vehicle, despite its advantages over variable annuities as an estate-planning instrument.

Death Benefit Passes Tax-Free

The big advantage of SPL is that it passes the death benefit to your heirs tax-free (although there may be estate taxes to consider). In many cases, those benefits also will pass to heirs outside of probate, a real plus for larger estates.

"If you put $50,000 into both a variable annuity and single-premium life policy and they're both worth $200,000 in death benefit, there is zero tax consequences for the SPL if it's been set up correctly, while you're going to have $150,000 in income on the annuity contract that the heirs will have to pay tax on at ordinary income rates," says Hasenauer. "The best you can do with the annuity is amortize that tax hit over five years."

Because the premium is paid in full upfront, there's no danger that the policy will accidentally lapse. What's more, the insurance portion will be entirely paid by investment gain rather than with annual premiums. "That means it's paid with pretax dollars rather than after-tax dollars," Hasenauer notes.

On the minus side, you must be able to qualify for life insurance and you won't be able to increase the death benefit of an SPL policy without additional underwriting.

Dan Prescott of Prescott Pailet Benefits of Dallas, admits he rarely sees single-premium life used as a stand-alone product these days. Where it comes in handy, he says, is as a means to consolidate stray life insurance policies in an estate through a 1035 exchange.

"If somebody has four old whole-life contracts with $250,000 worth of cash surrender value and an $800,000 cumulative death benefit built up, if they're insurable, we're able oftentimes through a 1035 exchange to do a new no-lapse-guarantee universal life policy and obtain maybe a $1.2 million death benefit for the same $250,000 deposit without any additional premiums being required," he says.

Who benefits from SPL?

Who might benefit most from an SPL? Hasenauer says it is best suited for those who want to set aside a large sum they'll never need themselves for the next generation.

"If you're a short-term investor, you don't belong on the life side, which is a product designed for your ultimate end of life," she says. "If you have a need for the insurance to fund a trust for heirs or a special-needs grandchild who will require lifetime income, this is the perfect investment for that. You just put it aside, you know it's there, and it's going to build rapidly."

Al Barnes, a life insurance specialist based in Alabama, says applicants age 55 and under with a 30-year time horizon have the best chance of maximizing an SPL. "Someone who is 75, who's looking at maybe a 12-year time horizon, they'll probably want guaranteed universal life to get the biggest bang for their buck," he says.

But because of the complexities of estate planning with life insurance products, when it comes to parting with a sizable chunk of cash, he recommends finding a crack financial planner first.

"(SPL) gives you a respectable death benefit with that money, therefore it has a use," he says.

"Now, should that be your use? That's where you need advice from somebody who is not selling it to you."

In Barnes' view, there's a simple way to end the confusion over single-premium life.

"Single-premium life is not an investment product and a deferred annuity is not an estate-planning tool," he says. "A variable annuity is during-life money and single-premium whole life is after-life money."