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Question for the Money Doctors

Question submitted on Jun 1, 2014.

Question

What type of investment vehicle allows for Market gains to be locked in, while guaranteeing "downside protection" when the Market drops? I've heard local talk radio programs espousing the merits of such investments and claiming tax-free withdrawals later in life. I believe it is called the RAFT Strategy or retirement Accounts Free of taxes... can you explain in layman's terms how it works, IF it works at all and how they can guarantee downside protection. Thanks!

Answer

Your question is an important question.

According to a website describing the RAFT strategy, the product used is an equity indexed life insurance policy and has a number of factors to consider in your decision making process.

The short answer is to tread extremely carefully.

What follows is not a simple answer, because this is a very complex financial contract that potentially exposes you to tremendous tax risk if you don't follow rules you are not familiar with.

A key factor is to read the contract and the fine print. Many insurance companies offer this type of product, and even the same company over time will offer variants of this program.

What to read in the contract:

1. Index used. Does it include dividend reinvestments? I have not yet seen a contract that does. Over the last 15 years, a substantial portion of appreciation of the SP500 is due to dividend reinvestment. Often times the illustrations will show the past ten years as if there had been , but their contract does not permit.

2. What is the participation rate of the index? Sometimes the contract stipulates up to 120%, but has the power to adjust down to usually around 30% at the annual reset period.

3. What is the cap? Many contracts are calculated monthly. Many contracts contain upside market caps, with no downside limitation. The monthly cap is usually between 1.25% to 1.75%. What this means is if the market goes up by. 4 percent one month and down by 3 percent the next month and the cap is 1.5 percent, the return for the contract is zero percent.

4. Over loan protection rider. This is the most important part of the discussion. In life insurance, if you save $400,000 and later borrow out $500,000 and accumulate another $300,000 of interest due to borrowing, you will owe taxes on $400,000 even though you never received a personal financial benefit of the interest due back to the policy if the policy lapses

In order to avoid the lapse, some insurance companies put in place an overload protection rider.

The language of this clause in the contract is important to read and understand as it usually carries a number of requirements to be fulfilled to be effective.

If it is not effective, the life insurance will be taxable beyond your imagination.

One contract I read indicated that we (the insurance company) will mail to you a premium notice ( neither date nor amount specified in the contract) which must be returned within 60 days or the rider is void.


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