Private credit has surged in popularity among investors, growing from $1 trillion in 2020 to $1.5 trillion at the start of 2024, according to alternative data provider Preqin. The firm projects this figure to reach $2.6 trillion by 2029. However, investing in private credit comes with a significant drawback: returns from direct lending are taxed as ordinary income, with a top federal tax rate of 40.8%, compared to long-term capital gains taxed at a maximum rate of 23.8%. This can cost investors millions in returns. For example, a $5 million investment in private credit could result in $4.3 million in tax drag over 10 years and $61 million over 30 years, according to Bernstein Private Wealth Management. To mitigate tax liabilities, investors have several options. The simplest method is investing through a Roth IRA, but these tax-advantaged accounts are unavailable to high earners. Instead, high-net-worth investors are increasingly using insurance to save on taxes. Instead of directly investing in a private credit fund, they take out insurance policies that invest the premiums in a diversified portfolio of funds. “You’re getting taxed on the insurance product, rather than being taxed on the underlying private credit investment,” explained Yasho Lahiri, funds lawyer and partner at Kramer Levin. These insurance dedicated funds (IDFs) have grown rapidly, though the exact number is unclear as many are unregistered. IDFs must be diversified to meet IRS requirements, which can lead to weaker returns than selecting a top-performing fund, according to Robert Dietz, national director of tax at Bernstein. However, these funds offer better liquidity than typical private credit funds. There are two primary options for investing in an IDF. The most cost-effective route is obtaining a private placement variable annuity (PPVA) contract with an insurance carrier. Dietz noted that these annuity policies can be suitable for clients with investible assets ranging from $5 million to $10 million. However, the associated income taxes are only deferred until the policy owner withdraws or surrenders the contract. “At some point someone’s going to have to face that deferred income tax liability,” Dietz said. “That might be the individual who is purchasing the annuity if they decide to take a distribution out in the future, or it could be their beneficiaries when their beneficiaries inherit the annuity.” The most tax-efficient option is obtaining a private placement life insurance (PPLI) policy. When structured correctly, the policy owner’s death benefit is untaxed when paid to beneficiaries. Some clients are deterred by the multimillion-dollar upfront premium and complex underwriting of PPLI policies, but it can be worthwhile. Dietz stated that these vehicles can be appropriate for clients with at least $10 million in investible assets. “If my policy is not structured carefully, my insurance costs can become very expensive, and that can start to eat away at the benefit I’m getting from that cash value accumulating in the policy,” he said. Since PPLI and PPVAs are unregistered financial products, one must be an accredited investor or qualified purchaser to access them. Accredited investors must earn at least $200,000 annually or have a net worth exceeding $1 million, excluding a personal residence. For qualified purchasers, the investible asset minimum rises to $5 million. Despite these thresholds, IDFs have become more accessible due to inflation and stock market growth, according to Lahiri. PPLI, a powerful tax avoidance tool, can be used without IDFs to pass down a wide array of assets, including entire businesses, tax-free. It has drawn congressional attention, with an investigation by the Senate Committee on Finance describing the PPLI industry as “at least a $40 billion tax shelter used exclusively by only a few thousand wealthy Americans.” Senator Ron Wyden, D-Ore., then chair of the committee, drafted a proposal in December to curb the tax advantages of PPLI, but this bill is unlikely to pass with a Republican-controlled Congress. The talk of potential legislation briefly deterred clients from PPLI last year, according to Dietz. Client demand for private credit and tax-efficient investment methods continues to grow. “Family offices and ultra-high-net-worth clients are seeking ways to maximize after-tax returns, and the low-hanging fruit – the long-only equity portfolios and tax-loss harvesting – has already been implemented,” he said. “We’re definitely having more conversations with clients around this.” — news from CNBC
