CFP® Questions & Misconceptions: Insurance Planning

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The BIF Bites podcast covers topics that are important to those seeking CFP® certification and really anyone that wants to better understand the financial services industry in general.

Mike Long, CFP®, ChFC®, CLU® is the Co-Director of Curriculum for the Boston Institute of Finance (BIF). He has made his career in financial services and financial services education over the past 40 years.

Transcript

00:00:08 

Hello CFP fans, this is the BIF man, Mike Long. Welcome to another amazing episode of the BIF Bites Podcast. So, we've been doing this series of questions and misconceptions on some select CFP Exam topics, and I had three I wanted to add to the mix from the insurance category. 

00:00:36 

And as I mentioned before, these are topics that in the last exam cycle we saw maybe higher than average confusion or missed practice questions or mock exam questions or they didn't quite connect with some of the highly testable points of a topic, so I'm just going to share three of those with you in this episode. 

00:01:04 

I want to talk a little bit about the relationship of high-deductible health plans to HSAs and as a lot of you know, I'm a big fan of HSAs. There's a whole podcast episode on HSAs, but I want to focus on this deductible and [maximum] out of pocket that I saw some confusion with. I'd also like to touch on basis as it relates to buy-sell agreements. 

00:01:30 

And then the third piece is a couple of points on modified endowment contracts. But again, I'm looking for things that (where did I see a high volume of e-mail questions to us at the BIF review and in the practice questions and mock exam) where there were [frequently] missing of these questions.  

00:01:52  

So, we know HSAs are great, and it's a wonderful tax benefit to be able to deduct contributions into an HSA, have, worst case scenario, tax-deferred earnings on the account. Hopefully they'll ultimately all be tax-free because the funds are used for eligible medical exams.  

00:02:18 

And then, the third piece of the trifecta for tax benefits for HSA’s, is that those ones can come out tax free to pay for eligible medical expenses. It's very rare for something to have all three of those - deductible or pre-tax contributions, tax-deferred or tax-free earnings [and] tax-free distributions. That's really rare. 

00:02:39 

Where I saw some confusion—there's no confusion on the numbers from contribution standpoint because those numbers are given in tax tables. So, that's not an issue. But what [where] I saw some confusion is the relationship with the deductibles and maximum out of pockets expenses for qualified, high-deductible health plans. 

00:03:03 

So, we're always given the numbers and again these numbers, the deductible and max out of pocket will be on the tax tables for the exam. You don't have to memorize them, but you do have to know how to use them, and I'm just going to use 2023 as an example. You might be listening to this in 2024 at 25, [but] it doesn't matter because you're going to have your numbers on the tax tables. 

00:03:24 

But I'll use 2023 as the example, so to be eligible for an HSA, one has to be covered by an eligible high-deductible health plan and for CFP Exam purposes, we would be looking at the deductible and the max out of pocket. For example, in 2023 [a] self-only coverage, high-deductible health plan has to have a minimum deductible of $1500. Family coverage has to have a minimum deductible of $3000. 

00:03:58 

Now it can be higher. That's just the minimum, so the figure for the deductible is a minimum value, but it can be higher than in those respective plans. The maximum out of pocket amount in this plan for self-only cannot exceed $7,500 and for a family plan the maximum out of pocket cannot exceed $15,000.  

Now, where the confusion came that I saw in this most recent exam cycle is understanding that [the] maximum out of pocket includes the deductible that the insured must pay. 

00:04:44 

So how does that relate?  

Let's use the family as an example. The minimum deductible in family coverage is $3,000, [and] he maximum out of pocket is 15,000. So, when a plan is right on the numbers, if there's a $3,000 deductible, that means [that] the out-of-pocket element co-pays and so forth. 

00:05:10 

They're going to be exposed to another $12,000, the $15,000 Max, minus the $3,000 deductible.  

00:05:19 

And here's the catch on these kinds of exam questions. What if the deductible in the plan is $5,000? That's OK. Some students will say, oh, well, it's not eligible. It's $3,000. Well, that's the minimum.  

But if it's $5,000, that means that the maximum out-of-pocket exposure cannot be more than $10,000—he $15,000 max minus the $5000 deductible.  

So, watch for those questions.  

That's a little tricky because we want to disqualify a policy if they have a higher deductible or a lower maximum out-of-pocket [cost]. That's the other way this could turn is that $15,000 is the maximum, but it could be lower. 

00:06:13 

So, think about that math. Think about that relationship in the HSA-type questions, and I think you should be OK with an exam question that tests the application of that. So, hopefully that can clear it up if you've had some confusion with that on our first topic in this episode. 

00:06:34 

Next topic that I saw some confusion with was about how cross purchase agreements funded with life insurance work. But I got more questions on this related to the basis to the holder after the buy sell agreement has been executed. 

So, for CFP Exam purposes, the testing has always been either on a cross purchase buy sell agreement or an entity purchase stock redemption buy sell agreement. 

00:07:17 

And the unique piece here that I saw some confusion with is [how] it relates to cross purchase. So, in a cross purchase buy sell agreement, each of the owners (and the cross purchase works best if there's not a lot of owners because the number of policies involved gets quite large.  

But each owner owns a life insurance policy on their respective owners. On the other, other owners of the company in the amount necessary to buy out that fractional piece. 

00:07:55 

So if there's just two owners, each owns a life insurance policy on the other for 50% of the agreed upon value of the business and the individual owners own and pay for the life insurance on the other respective owners at death.  

00:08:16 

And then there's a binding agreement, of course, at death, the surviving owner receives the proceeds from the life insurance policy. So, they get cash and then they turn around and use that cash to execute the buy sell agreement and buy out the decedents’ interest in the company.  

That's where the basis piece comes in, because we have to look at what transpires here separately. First, there's a death, and cash comes to that surviving owner. That piece is done, but then they take that cash and buy the decedents’ interest. 

00:09:04 

And that's why their basis goes up. So, the surviving owner's basis will increase by the amount of the purchase by the life insurance that they used to purchase the decedents’ interest.  

00:09:18 

So if that piece was $1,000,000, the survivor's basis in that company moving forward should they ever sell the company, their basis would be their original basis, whatever that was plus the $1,000,000 of life insurance money that they took and executed the buy sell agreement, that's a huge differentiation between cross purchase by sell and entity purchase by sell there is a there is an increase in basis where there is not in in entity purchase because the surviving owner in an entity purchase by sell didn't put more cash in they don't receive cash from their life insurance policy and in entity purchase, the company does. 

00:10:11 

The company is the owner and payor of the life insurance, and they use the proceeds to then redeem the stock [or] to redeem the business interest of the decedent, leaving full ownership of the company to the surviving owner or owners.  

There is no increase in basis under the entity purchase. So, if sold down the road by the surviving owner, there could be a larger capital gain, but particularly on the side of the cross purchase. 

 I saw some confusion and [misunderstanding] how there's an increase in the basis.  

00:10:49 

So that was the second topic that I wanted to touch on in this episode, and hopefully, that helps you out on your exam question. 

00:11:02 

All right. Finally, the third topic that I wanted to talk about in this episode is modified endowment contracts.  

This is a complex topic—in real life, this is complex, and we typically need tax help on this one. However, it's not complex in CFP-Land for the exam. So, on the exam they would have to tell us that it's failed. They're never going to test us doing the math on whether it failed or didn't fail; they're going to tell us it failed. And it's a modified endowment contract. 

00:11:43 

And so what that change is the tax treatment of living distributions from that contract. It doesn't change the tax-free status of the death benefit.  

That's a good exam question, but it does change potentially the tax treatment of living distribution. So, what would a living distribution be? Well, that in CFP Exam-Land that's going to be a loan or withdrawal from a universal life policy.  

00:12:17 

It might just be a straight up withdrawal, or it might be a loan. Now, this gets confusing because we're taught that loans from life insurance policies are tax-free. But that changes if it's a Mac.  

But the confusing piece here is that the taxation is based on the gain that exists in the policy. So, if the policy has not reached gain status (meaning that the cash value of the policy is more than the aggregate premiums that have been paid in). 

00:12:54 

Then we don't have a game. But probably in Exam-Land, there's going to be a gain. And you have to know how to treat that. Basically (as you maybe have heard me say even in the review or in the Bryant Education courses), it just flips the tax treatment to be that really the same as an annuity. 

00:13:15 

In an annuity, distributions are considered earnings first and taxable as ordinary income. That's how it comes in a living distribution from a MetLife insurance policies. Earnings first is ordinary income, and just like an annuity, those taxable earnings would be subject to 10% penalty if this distribution is happening prior to age 59 and 1/2. 

00:13:51 

But you have to watch out if you're given math in this question, you have to watch out if you're giving total premiums paid in, and you're given a cash value number. You've got to look at that and say, is there even a gain right now, in this policy? Because if there isn't, it doesn't matter that it's taxed on a LIFO basis. 

00:14:11 

Because there's no gain, there's nothing to pay taxes on, so check that math. That's the most common thing that I saw in the exam cycle of students missing a question because they weren't checking the math to see if there was a gain in the first place. Keep it simple. Mechs are very complex, but not for the exam.  

00:14:31 

You just need to know a couple of basic things, and you're going to get this question right on the CFP exam. So hopefully that helps on this third topic in this short episode of the BIF Bites Podcast, and we'll be putting out the remainder in this series shortly so study on my friends and we'll see you again.