by Zaahirah Souri, Product Analyst
If you have a client who is ready to make a one-time payment on a life insurance policy, you’ll want to make sure they keep all the tax advantages that life insurance policy has to offer. Many policies that are paid for with a substantial single premium exceed the annual premium limit guidelines. This causes the policy to become a modified endowment contract (MEC) with potential tax penalties. That is why some carriers offer a Premium Deposit Account (PDA) option. A PDA provides the convenience of funding the policy with a one-time payment along with a non-MEC premium structure.
How does it work? A PDA is a fund that will hold your client’s one-time payment and automatically pay the premiums into a life insurance policy. The main advantages of a PDA are seen through its three simple steps:
- A PDA allows you to take a lump sum of money and structure premium payments to prevent the policy from becoming a MEC – the client will not have to worry about making additional payments.
- After paying the first planned premium into a life insurance policy, the remainder of the lump sum begins to accumulate interest in the PDA. (Note: interest earned on PDAs is taxable.)
- Future premiums are automatically paid into the account but at a discounted rate (planned premium minus interest earned in that year). This allows the client to pay less out-of-pocket while using the interest to earn more value for their money.
PDAs are especially useful for clients wanting to make a one-time payment on an accumulation focused life insurance policy where cash might be withdrawn for future financial needs (e.g. supplemental retirement income). Since the PDA spreads the premiums, the initial death benefit and associated charges are reduced, which creates an opportunity for greater cash accumulation. Additionally, at the end of all premium payments, the lump-sum plus the additional interest accrued in the PDA will be paid into the policy. This will further increase cash accumulation in comparison to paying the divided lump sum amount directly into the policy and not funding it through the PDA. Single pays are less suitable to a PDA when trying to optimize cash accumulation because they cause charges in the policy to be greater, due to a higher initial death benefit.
Clients who are only focused on death benefit protection also gain some advantages in using a PDA. The interest earned in a PDA can potentially reduce out-of-pocket expenses to a client for the same death benefit amount, depending on how the product performs. Or, for the same premiums plus any interest earned in the PDA, it is possible to buy a larger death benefit. This advantage would be easier to calculate for term and guaranteed products, though less predictable for other universal life products. Also, the nature of PDAs’ premium payments provide security for strict guaranteed products where late or missed payments largely decrease the length of guarantee.
All PDAs function the same, but some key features are worth considering when planning your client’s financial strategy:
Interest earned on PDAs is approximately 2% on average and is either declared yearly or at the time of the initial premium payment. The most competitive interest rates can go as high as 3.5-4%, as seen on Securian Financial and Penn Mutual’s PDAs.
Deposit amounts into PDAs are limited. Minimum deposits vary by carrier, ranging from $250 — $40,000 while most cap the allowed lump-sum at ten times the annual premium. Some PDAs, however, allow deposits of up to $10 million.
Planned premiums are generally required to be scheduled from two to ten years. National Life’s PDA, though, gives you the option to plan premiums for as long as 20 years.
No extra cost is typically associated with the use of a PDA, and they can be withdrawn with little to no penalty, depending on when the money is taken out. In the event of the death of the insured, the policy’s beneficiary will receive any remaining PDA funds.
These accounts are available across all types of life insurance, from term to permanent products. So if you have a client wanting to pay for a policy up-front, it might be advantageous to look into policies with premium deposit accounts: the interest can “discount” the premiums, premiums are automatically paid on time, and the tax advantages of your client’s life insurance policy are maintained. A list of products with PDA options is available on the LifeTrends website.