Calculating Taxable Income when Surrendering a Whole Life Insurance Policy Before Death

In general, whole life insurance involves overpaying ten times the cost of term insurance and placing that extra money into a separate account.

The State of California categorizes Whole, Universal, Variable, Indexed and several others under the category of Whole Life Insurance (as opposed to Term Life Insurance).

In order to determine the gain within a Whole Life Insurance policy, you must first calculate the cost basis.  The cost basis in most cases is just the total amount of premiums paid on the policy (see finance.zacks.com for more information).  In rare cases, there may be distributions in which case the distributions will reduce the cost basis.

Next, you determine the surrender value.  A common misconception is that a life insurance policy is worth the account value.  However, a more accurate estimation of value is today's value, which is the surrender value.

Gain = Surrender Value - Premiums

Compare this to a typical gain for any investment, such as a home:

Gain = Sale Price - Cost Basis

The Gain will be taxed under the IRS code 7702.  This gain is reported as ordinary income.  This is unfortunate, because most policies result in a loss and a capital loss would have the option to be offset with a capital gain.

How Can Financial Institutions Be More Transparent?

Consider these questions when thinking about a particular investment portfolio. Is it possible that fund performance is not quite as important as we thought? How much are hidden fees and charges are affecting your bottom line? With all the information given by financial institutions, how can we really simplify our life and figure out how we are doing? How can we determine our financial velocity?

When in comes down to it, your fund performance, while important is not the most important. Your sales charges or management fees are also not that important. What is most important is your bottom line, which takes into account both performance and charges. In other words, rather than looking at income or expenses, lets look at profit. When you look at your account, you want to know what your personal rate of return is.

When looking at your personal rate of return it is critical to take into account the dates of your deposits and your current value. Luckily, when it comes to current value, the valuation of portfolios is fairly accurate due to the liquidity of stocks. This is not the same as car or home valuation. On the other hand, the time value of money should be taken into consideration.

If you deposit $500 during the year and your money at the end of the year is $1000, the day you deposit has a large impact on the personal rate of return. If you deposited the money near January 1st, your personal rate of return would be close to 100%. If you deposited your money around December 28th, your personal rate of return would be closer to 10000%!

With all this in mind, institutions like Charles Schwab and Fidelity have been including personal rate of return in their statements. I did an independent audit and found the following:

See the algorithm at sizustech.blogspot.com
This is what I found...

Case I

The following data represents deposits for the last quarter of 2013:

var currentNetWorth = createTransaction("12/31/2013", 4073.99);
var paymentArray = [];
paymentArray[0] = createTransaction("09/20/2013", 500.00);
paymentArray[1] = createTransaction("10/04/2013", 500.00);
paymentArray[2] = createTransaction("10/18/2013", 500.00);
paymentArray[3] = createTransaction("11/01/2013", 500.00);
paymentArray[4] = createTransaction("11/18/2013", 500.00);
paymentArray[5] = createTransaction("12/02/2013", 500.00);
paymentArray[6] = createTransaction("12/13/2013", 500.00);
paymentArray[7] = createTransaction("12/27/2013", 500.00);

The financial institution showed a 2013 rate of return as 3.6%. My calculation showed 13.60%.

Case II

The following data represents deposits for the first and second third of 2014:

var currentNetWorth = createTransaction("8/15/2014", 12011.36);
var paymentArray = [];
paymentArray[0] = createTransaction("12/31/2013", 4073.99);
paymentArray[1] = createTransaction("1/13/2014", 450.00);
paymentArray[2] = createTransaction("1/27/2014", 450.00);
paymentArray[3] = createTransaction("2/10/2014", 450.00);
paymentArray[4] = createTransaction("2/20/2014", 450.00);
paymentArray[5] = createTransaction("2/28/2014", 376.82);
paymentArray[6] = createTransaction("3/07/2014", 450.00);
paymentArray[7] = createTransaction("3/21/2014", 450.00);
paymentArray[8] = createTransaction("4/04/2014", 450.00);
paymentArray[9] = createTransaction("4/17/2014", 456.08);
paymentArray[10] = createTransaction("5/02/2014", 456.75);
paymentArray[11] = createTransaction("5/16/2014", 456.75);
paymentArray[12] = createTransaction("5/30/2014", 456.75);
paymentArray[13] = createTransaction("6/13/2014", 456.75);
paymentArray[14] = createTransaction("6/27/2014", 456.75);
paymentArray[15] = createTransaction("7/11/2014", 456.75);
paymentArray[16] = createTransaction("7/25/2014", 456.75);
paymentArray[17] = createTransaction("8/08/2014", 456.75);

The financial institution showed a YTD rate of return as 3.2%. My calculation showed 6.19%.

Notice that to calculate YTD, you need to take into consideration the value of the portfolio at the end of the previous year.

Case III

The following data represents the combined deposits:

var currentNetWorth = createTransaction("8/15/2014", 12011.36);
var paymentArray = [];
paymentArray[0] = createTransaction("09/20/2013", 500.00);
paymentArray[1] = createTransaction("10/04/2013", 500.00);
paymentArray[2] = createTransaction("10/18/2013", 500.00);
paymentArray[3] = createTransaction("11/01/2013", 500.00);
paymentArray[4] = createTransaction("11/18/2013", 500.00);
paymentArray[5] = createTransaction("12/02/2013", 500.00);
paymentArray[6] = createTransaction("12/13/2013", 500.00);
paymentArray[7] = createTransaction("12/27/2013", 500.00);
paymentArray[8] = createTransaction("1/13/2014", 450.00);
paymentArray[9] = createTransaction("1/27/2014", 450.00);
paymentArray[10] = createTransaction("2/10/2014", 450.00);
paymentArray[11] = createTransaction("2/20/2014", 450.00);
paymentArray[12] = createTransaction("2/28/2014", 376.82);
paymentArray[13] = createTransaction("3/07/2014", 450.00);
paymentArray[14] = createTransaction("3/21/2014", 450.00);
paymentArray[15] = createTransaction("4/04/2014", 450.00);
paymentArray[16] = createTransaction("4/17/2014", 456.08);
paymentArray[17] = createTransaction("5/02/2014", 456.75);
paymentArray[18] = createTransaction("5/16/2014", 456.75);
paymentArray[19] = createTransaction("5/30/2014", 456.75);
paymentArray[20] = createTransaction("6/13/2014", 456.75);
paymentArray[21] = createTransaction("6/27/2014", 456.75);
paymentArray[22] = createTransaction("7/11/2014", 456.75);
paymentArray[23] = createTransaction("7/25/2014", 456.75);
paymentArray[24] = createTransaction("8/08/2014", 456.75);

The financial institution showed a lifetime rate of return as 6.2%. My calculation showed 6.96%.

As a sanity check, if the 2013 rate of return was 3.6% and the YTD rate of return was 3.2%, how could the lifetime rate of return be 6.2%?

Know your personal rate of return. This will help you weed through the fund performance charts, the sales charges, the hidden fees, reported returns, etc.

This post was reposted from http://finlit.biz/uncategorized/how-can-financial-institutions-be-more-transparent/, originally written on August 15th, 2014.

How Much is Cable Really Costing You?

Have you ever considered how much cable is really costing you?

Well this example can be applied to any monthly expense. Consider this from the blog posting at sizusfinlit.blogspot.com.

"Some families are very happy because they earn over $200,000 with a combined income. However, this is no match for a simple cable bill, which is paid $120 per month for the entire life of most people. Using the average age newborns live to, which is 80, this becomes $115,200 of payments over one's life. If I factor in compound interest, paying $1440 annually at a 5% interest rate, this becomes $1,468,498. Wow, looks like the $200,000 just went out the window when you decided to own cable throughout your entire life, costing $1,468,498!"

This post was reposted from http://finlit.biz/estate-planning/how-much-is-cable-really-costing-you/, originally written on August 9th, 2014.

Residual Income, The Dream Killer or The Dream Creator?

Today, I want to discuss a fundamental concept called residual income. A related concept is passive residual income.

Have you ever asked why and how society funnels money, eventually leaving 15% of families poor, 80% as middle class and 5% of the population as wealthy? Have you ever wondered why the rich get richer? Or why is it that by age 65, 90% of the population is working or dependent, 5% is wealthy and the other 5% deceased?

What is inflation? Well, inflation is used so that the money people stuff under their mattress eventually becomes useless. It is a 3% funnel back into society.

What are taxes? Taxes are a chunk of income used to return a portion of what people earn to pay for government expenses. It is another 35% residual income for society.

What is a credit card? Well, it a 3% service charge funneling your money to credit card companies with each swipe.

What is a mortgage? A mortgage is a 30 year contract to remove the residual income from rent. By the way, financially speaking, the ability to have control over possibly reducing rent may be more valuable than having the mortgage.

What is a grocery store? It is a residual expense to keep you fed, despite the fact that you might be able to handle your own food production.

Now, if that weren't enough, companies became smart and started adding to the list of expenses that you need each month. You have mortgages, rent, electricity, water, gas, telephone, cable, internet, newspaper/magazine/gaming/online subscriptions, property taxes, fitness memberships, health insurance, home insurance, whole life insurance, and car insurance/registration/gasoline.

Some families are very happy because they earn over $200,000 with a combined income. However, this is no match for a simple cable bill, which is paid $120 per month for the entire life of most people. Using the average age newborns live to, which is 80, this becomes $115,200 of payments over one's life. If I factor in compound interest, paying $1440 annually at a 5% interest rate, this becomes $1,468,498. Wow, looks like the $200,000 just went out the window when you decided to own cable throughout your entire life, costing $1,468,498!

The wealthy know that high salaries mean very little. Just look at the lottery winners and athletes that have gone broke after 5 years (there are other reasons of course and this may be a whole blog in itself). It is those who eventually have more residual income flowing in than out that win over the long run. Wealthy people probably didn't purchase cable until they had enough passive income to cover it.

Now, if you have gotten a chance to create a solid passive residual income stream, how would you feel knowing that legislation existed to ensure its stability?

What is really interesting is if we look at how each of the previous decades has brought an additional product or service to market which introduced an additional passive income stream for a new company.

Another interesting concept is looking at what it would take to accumulate $50,000 of passive residual income rather than looking at what it would take to accumulate 1 million dollars which might indirectly be used to bring $50,000 of passive residual income.

Dedicated to Adam Ward.

This post was reposted from http://sizuservices.blogspot.com/2012/12/residual-income-dream-killer-or-dream.html, originally written on December 26th, 2012.

Should You Pull Equity From Your Home for Investment Purposes?

I wanted to share the personal story of a woman I spoke with this month. While I will keep her identity private, I think others can benefit from hearing this story. It is important because it is through our experiences and the experiences of others that we learn. This is where we discover that theory sounds good and great, but application rarely matches theory.

This woman was convinced to take 350,000 equity out of her house, putting 175,000 into two life insurance policies that were supposed to provide growth and tax free retirement.

She ended up taking an interest only mortgage which switched after ten years to normal amortization. She ended up losing a big chunk from the life insurance policy, which didn't quite return what was implied by the hypothetical. Now, she doesn't even consider it as an asset. On top of that, now that the regular amortization hit, she is having trouble affording the payments.

Her mortgage is far from paid off and she is considering moving from the area, being only two or three years away from retirement.

Moral of the story. Only take money out from your home for an active business venture. This does not include home improvements or passive investing. It only includes jump starting a life long dream where you are actively involved in decisions and the direction of the business.

If you are considering whether or not your business venture qualifies for taking equity out of your home, consider Jim Collin's book from Good to Great, where he states that your purpose is the intersection of your passion, potential and profit.

This post was reposted from http://finlit.biz/estate-planning/should-you-pull-equity-from-your-home-for-investment-purposes/, originally written on August 9th, 2014.

Can You Build a Downpayment for a House in 5 Years?

Suppose you decided to rent for a while and you sold your house receiving a large lump sum. Suppose you also wanted to build you savings for a while to purchase another house down the road in, say 5 years. How much could you expect to save or grow your money?

For the short term, you want to protect your money as well as grow it. If you put down $100,000 and contributed $120 monthly for 5 years, you would use the following formula to calculate your growth.

P*(1+r)^y + sum_{n=0}^{y*12-1} M*(1+r)^(y-n/12)

where P is the original amount, r is the rate, y is the number of years and M is the monthly contribution.

You can use Javascript to calculate the growth: see sizustech.blogspot.com for code.

Based on this formula, the orginal amount of $100,000 would grow to $127,628 and the monthly contributions of $120 would add $8,170 which yields a total of $135,798.

Which sounds better, losing value at a rate of 3.5% due to inflation or investing wisely, shooting for a 5% return?

This post was reposted from http://finlit.biz/estate-planning/can-you-build-a-downpayment-for-a-house-in-5-years/, originally written on July 30th, 2014.

Five Reasons to Start Saving Before Paying Off Your Debt

Pop quiz: If someone has gotten themselves into $20,000 worth of debt over a 3 year period and all of the sudden receive an $30,000 inheritance, should they pay off their debt?

Answer: No. If they do, they will be back into $20,000 worth of debt in just a few years. It was the habits that got them into debt in the first place. They should focus on paying back their debt by saving from their income. Working their way out of debt will give them the discipline and habits to stay out of debt long term.

In general, it is counter intuitive to think that one should start to save before getting out of debt. After all, if you are saving with an interest rate of 9% and have debts with an interest rate of 15%, aren't you falling behind?

Perhaps, but people make decisions based on emotion and then justify their actions using logic. Here are the five reasons you should start saving while paying off debt:

1. Many people tell themselves they will start saving once they have paid off all their debts. In the end, they never pay off their debts and they never start saving. If you have reasons why you can't save money today, in your current situation, what makes you think you won't have plenty of excuses of why you can't save in the future?
2. If you aren't saving money for emergencies, the emergencies that come up will leave you in a bind. Any progress towards debt you made will be undone. You may even end up using high interest rate credit cards to pay for an emergency which will cause you to fall further behind.
3. Saving is a habit. If you don't start to develop the life long habit today, even if you happen to be one of the few who do become debt free, you will not have developed the habits necessary to continue to increase your net worth.
4. Debt is like weight. Most people have a certain level that they are comfortable with, even if it is unhealthy. While some people try to diet, years later, they find themselves at the same weight level. This is true with debt as well. Imagine saving only after you have hit your weight goal! Don't wait to start saving until after you have hit your debt goal.
5. Saving is one of the building blocks in your financial house. If you don't put the foundation in place, you will not be able to build on it later. Dave Ramsey's debt stacking strategy (see www.daveramsey.com) can be extended to continue the snowball into savings. If the building blocks are not set in place, however, months of savings will be found spent before they reach a savings account.

Thank you so much for visiting the site and taking an interest in your own personal finances. This means a lot to us. Please do browse the site and leave comments or questions.

This post was reposted from http://finlit.biz/debt/five-reasons-to-start-saving-before-paying-off-your-debt/, originally written on June 3rd, 2014.