Private credit has become a booming asset class on Wall Street, with the market growing from $1 trillion in 2020 to an estimated $1.5 trillion by early 2024, CNBC reports.
However, investing in private credit comes with a major tax drawback—returns from private credit are taxed as ordinary income, which can be subject to the top federal tax rate of 40.8%, rather than the more favorable long-term capital gains rate of 23.8%. This tax burden can result in millions of dollars lost over time.
To mitigate this, high-net-worth investors are increasingly turning to insurance solutions that allow them to invest in private credit without incurring steep tax bills. Through strategies like Private Placement Variable Annuities (PPVA) and Private Placement Life Insurance (PPLI), investors can save tens of millions of dollars in taxes over the life of their investments.
Investing directly in private credit funds may result in significant tax liability, especially for wealthy individuals. For instance, a $5 million investment in private credit could incur $4.3 million in taxes over the next 10 years and $61 million over 30 years. This tax drag has prompted high-net-worth individuals to seek alternatives to help manage their liabilities while still participating in this lucrative asset class.
One popular option for these investors is the use of insurance policies that invest premiums in a diversified portfolio of funds, including private credit. These insurance products, which include PPVAs and PPLIs, allow investors to benefit from private credit exposure while avoiding direct taxation on the underlying investments.
According to Yasho Lahiri, a partner at Kramer Levin, the tax advantages of these strategies stem from the fact that investors are taxed on the insurance product rather than the underlying private credit fund.
There are two primary insurance options for private credit investing: PPVA contracts and PPLI policies.
Private Placement Variable Annuities (PPVA): This option is typically best for investors with $5 million to $10 million in investable assets. Although these policies defer taxes on income until the investor takes a withdrawal or surrenders the contract, the taxes are eventually owed.
Private Placement Life Insurance (PPLI): Considered the most tax-efficient option, PPLI policies allow the death benefit to be passed to beneficiaries tax-free, providing significant estate planning advantages. However, these policies can be complex and require substantial upfront premiums, making them suitable for those with $10 million or more in assets.
While these products are unregistered and only available to accredited investors or qualified purchasers, the accessibility of these tax-advantaged strategies has increased as stock market growth and inflation have raised the asset thresholds required to qualify.
Despite their benefits, PPLI and PPVA products have their drawbacks. According to Robert Dietz from Bernstein Private Wealth Management, the funds used in these strategies must meet IRS diversification requirements, which can lead to weaker returns compared to selecting top-performing private credit funds. Additionally, the insurance costs for PPLI can be high if not properly structured, potentially eating into the benefits of the accumulated cash value.
The PPLI strategy has attracted legislative scrutiny due to its tax-saving potential. In December, Senator Ron Wyden proposed a bill that would curb the tax advantages associated with PPLI, which is currently estimated to be a $40 billion tax shelter for a select group of wealthy individuals. However, with a Republican-controlled Congress, this legislation is unlikely to pass in the near future.
Despite the potential for regulatory changes, demand for PPLI and PPVA solutions remains strong. Family offices and ultra-high-net-worth clients are increasingly exploring ways to maximize after-tax returns as traditional tax strategies like tax-loss harvesting and long-only equity portfolios have already been optimized.
