Life Insurance: Maximizing Income Tax Advantages

Life insurance is a valuable tool for personal and business financial planning, offering tax-favorable cash value accumulation and access to the cash value in the policy. While the primary function of life insurance is to protect loved ones in the event of your death, it can also help you and your beneficiaries manage tax consequences. Here are some of the key income tax advantages associated with life insurance:

Death benefits are usually tax-free

The death benefit, or the sum of money paid out to beneficiaries, is generally not taxed as income. This is a straightforward benefit for your heirs or other beneficiaries, as life insurance policy payouts can be large, and avoiding a major tax bill can be consequential.

However, there are some exceptions to this rule. For example, if the policy accrued interest, taxes are usually due on the interest earned. If the policyholder names their estate as a beneficiary, taxes may also be applied, depending on the estate's value. If the insured and the policy owner are different people, taxes may also be involved.

There are ways to avoid these taxes, such as transferring ownership of the policy to another person or entity, or setting up an irrevocable life insurance trust (ILIT). This ensures that the proceeds are not included in your estate.

It is important to note that while the death benefit is usually tax-free, it can increase the value of your estate if you own the policy. This could trigger federal estate taxes, which range from 18% to 40% for estates valued above $12.92 million in 2023.

Cash value growth is tax-deferred

Permanent life insurance policies, such as whole life insurance and universal life insurance, offer a cash value component that grows over time as you pay your premiums. This cash value is often used as an investment-like savings account, and the growth of this value is tax-deferred. This means that the cash value grows without the IRS taking a percentage, allowing you to accumulate more savings over time.

The tax-deferred status of the cash value growth is a significant advantage, as it enables your money to grow faster since it is not reduced by taxes each year. This benefit is especially valuable for those in higher tax brackets during their working years, as they can benefit from tax-free growth and then withdraw the money during retirement when they are likely to be in a lower tax bracket.

It is important to note that the tax-deferred status of the cash value growth is dependent on specific guidelines, such as those outlined in tax code 7702. If the amount of money put towards the cash value exceeds these limits, it may become subject to taxes. Additionally, there are certain instances where federal and state estate taxes may apply to the proceeds of a life insurance payout, so consulting a financial professional is advisable.

The ability to accumulate a substantial cash value over time without immediate tax consequences makes permanent life insurance policies an attractive option for those seeking to maximize their savings. However, it is essential to weigh this benefit against the typically higher cost of these policies compared to term life insurance.

Withdrawals are tax-advantaged

Permanent life insurance policies, such as whole life insurance, allow you to access the cash value of your policy through tax-advantaged loans or withdrawals. This provides you with greater flexibility to use your funds as you see fit. For instance, you can use the money to supplement your retirement income, pay for unexpected medical bills, or prepare for future expenses like funding an education.

The cash value of your whole life insurance policy will not be taxed while it's growing. This is known as "tax-deferred", and it means that your money grows faster because it's not being reduced by taxes each year. The interest you make on your cash value is applied to a higher amount.

If you want to access the cash value that has accumulated in your policy, you can take out loans or withdraw the money without tax consequences (as long as they're structured properly). Make sure you work with your insurance professional to help you avoid unnecessary taxation. There are many reasons you may want to borrow or take out cash — a loan without needing bank approval, college fees for a child, a property down payment, or cash to use in retirement.

It's important to note that any loans and withdrawals from the cash value of your policy may affect the death benefit amount and may require the need for additional premiums. Additionally, if you withdraw more than your basis in the policy, a portion of the withdrawal will be considered taxable income. Withdrawals are generally treated as coming out of your policy basis first. For example, if you have a cash value of $18,000 and a basis of $12,000, withdrawing $12,000 or less will have no income tax consequences. However, withdrawing $15,000 will result in income tax on the remaining $3,000.

Another option to access your money without incurring surrender charges is to take a policy loan from the insurance company, using the cash value in the policy as collateral. The amount you borrow is generally not treated as taxable income as long as you repay the loan. However, you'll have to pay interest on the loan, which is not tax-deductible.

Interest earned is taxable

Interest earned on life insurance is taxable. This is a key consideration when it comes to the tax implications of life insurance. While life insurance proceeds are generally not considered taxable income, and beneficiaries do not usually have to pay taxes on the death benefit, there are some exceptions. One such exception is interest. If the policy has accrued interest, taxes are typically due on that interest. This means that if you choose to leave the payout in an interest-bearing account, the interest earned will be taxable. This interest can be reported as interest received.

If you choose to receive lifetime or installment payments, you may receive more than the policy's death benefit if you live longer than expected. These payments are based on your age and the proceeds of the policy. While this option can provide a guaranteed income over time, the interest accrued will be taxable.

Interest earned on the cash value of a life insurance policy is also taxable if it is withdrawn beyond the "cost basis" or the total amount paid into the policy. This is an important consideration if you are planning to access the cash value of your policy. It is worth noting that dividends from the insurance company, which can increase the cash value, are generally not taxable.

In summary, while life insurance can provide tax advantages, it is important to understand the tax implications of interest earned on the policy. Interest accrued on the policy or on the payout, if left in an interest-bearing account, will generally be subject to taxation.

Dividends are usually not taxed

Life insurance can be an essential investment for protecting your loved ones if you pass away. Permanent life insurance policies, such as whole life insurance, generally pay dividends since they have cash value. Term life insurance does not pay dividends. Dividends are a sum of money the insurer pays to each policyholder based on the insurer's profits. Insurers generally pay dividends annually, and they are separate from cash value earnings.

Life insurance dividends are generally not taxable because the IRS considers them a return of premiums paid. However, there are a few exceptions to this rule. If your dividends exceed the total premiums paid, the excess may be taxable because any dividends over the amount you paid are considered income, not a return of premium. For example, if you pay $1,000 in life insurance premiums this year and receive a $1,250 dividend, you may owe taxes on the $250 excess.

You can leave your dividends in your policy to earn interest, but this interest income may be taxable if it earns you more than you have paid in premiums. Dividends that accumulate at interest are treated as distributions, and interest credited to a dividend accumulation account is currently taxable to the policyholder.

Policyholders can elect to receive their dividends in several ways. Many choose to receive their dividends in cash, which can be a good way to supplement your income or recoup some of the costs of your life insurance without reducing your coverage. You can also apply your dividends to future premium payments, which can help reduce the cost of coverage and ensure it doesn't lapse if you encounter financial problems. You can also let your dividends accumulate interest, which will help you grow your cash value as a source of wealth more quickly.

Frequently asked questions