Besides protecting the financial security of families and other dependent people from a person’s death, life insurance is also a fantastic way to pass along money while avoiding paying taxes on it. The tax advantages do not end there though. Many people may have heard that life insurance proceeds are not usually taxable to beneficiaries, but there are many more ways that life insurance saves people tax dollars every year. Here are 5 ways that life insurance can help you avoid paying taxes, making the IRS hate life insurance.
Reason #1 Dividends Can Grow The Cash Value Tax Free
Whole life insurance policies pay dividends. These are annual payments from the insurance company to policy owners, which may vary based upon several factors such the current cash value in the policy, the performance of the company the previous year, and current interest rates.
Policy owners have a choice of what to do with these dividend payments, but many people choose to use them to pay the premiums due for the policy, and to buy more paid up life insurance with the excess amount of the dividend which is left over after the insurance costs are paid.
The result is that without the owner paying any money into the policy, dividends will grow the cash value, as well as the face amount of the life insurance coverage. Because more dividends are paid when the cash value is higher, a compounding effect occurs which to makes dividend payments even larger in future years. As long as the money stays in the policy, there are absolutely no tax implications for the owner.
Even if the owner decides to take the cash value out of the policy one day, the policy has grown tax deferred in the meantime, which increases the real net return to the owner. This is part of the reason that life insurance can be such a good investment.
Reason #2 Loans Can Be Taken Tax Free
Owners are allowed to take out loans against the cash value built up in an insurance policy. Normally, owners can take out almost the entire cash surrender value of their life insurance contract in the form of a loan, and still keep the policy in force. Loans from life insurance are never taxable, and they can be taken out for any reason, whenever the owner wants.
The only instance when the amount taken out as a loan will become taxable to the owner, is in a case where the policy lapses with the loan outstanding, and more money is taken out of the policy in total than was paid into it. In other words only any gains made by the owner is taxable.
It is also true that the gain is taxable when withdrawals are taken from a policy. Even still, the withdrawals do get some tax preferred treatment however. The cost basis (the amount paid into the policy) is removed first from the policy, so withdrawals only become taxable when the last money comes out of the policy, and only if there is a gain.
Please note that if a policy is a modified endowment contract (more money was paid into it than allowed by law) the gain is considered to be removed first for tax purposes.
Reason #3 Life Insurance Cash Value Can Be Transferred To Another Policy Or Annuity Tax Free With a 1035 Exchange
Sometimes the cash value of a life insurance policy grows significantly greater than the amount of money paid into the policy. If the owner in this situation wants to surrender the policy, it will normally result in a large tax bill. A 1035 exchange is a way to prevent this from happening. A 1035 exchange allows the owner to preserve their tax deferred earnings by moving the money to another life insurance policy or annuity, completely tax free.
This most often results when certain changes in people’s lives and/or financial situations dictate that they no longer have a need for their existing life insurance coverage, but they may need either a larger or smaller policy to provide appropriate coverage for their current needs. They might want to use the cash value of an existing policy to fund the new policy, and a 1035 exchange allows for them to move this money over without incurring any taxes.
Sometimes people do not need new life insurance at all, but they want to avoid paying taxes on the proceeds of the surrender, and they want to invest the money in something that will grow in value even faster than life insurance. Life insurance tax laws also allow owners to move their existing policy value into an annuity via a 1035 exchange. Moving money from a life insurance policy to an annuity completely defers any taxes until a time when the money is withdrawn. Deferring taxes means compounding growth and higher net returns to owners.
Reason #4 The Death Benefit Of Life Insurance Is Usually Tax Free
If a life insurance policy pays a claim, it is usually a very large sum of money by most measures. Many policies even provide coverage for over a million dollars. If a policy pays a claim, the entire death benefit will be paid tax free in most situations.
The only requirement for the death benefit to qualify as a tax free payment is for the owner of the policy to be someone different than the insured person for at least the previous three years of the policy’s existence. This is why many policies are owned by either the spouse of the insured person, or they are owned by a trust.
The person receiving the benefit of the policy is called the beneficiary. When used properly, life insurance can provide the beneficiary with a massive payment of money to secure their financial stability, and they will not owe any taxes on the sum they receive. This makes life insurance a very efficient way to provide much needed financial protection for families and others.
Reason #5 The Estate Tax Can Largely Be Avoided With Life Insurance
This reason is similar to the previous one, but this applies exclusively to the ultra rich. Life insurance becomes a ticket for them to pass along their liquid assets completely tax free to their heirs.
If some person has a large sum of money as an asset held as cash, instead of including this as part of the taxable estate when they pass away, they could instead fund a whole life insurance policy with a substantial portion. This will allow them to pass the entire amount to beneficiaries tax free, and the death benefit may even be much larger than the amount of money that was put into the policy. This potentially means that the the heirs wind up receiving even more money than they would have, and it is completely free of taxes.
This is why the ultra rich know that life insurance is such a smart tool to pass their assets on to their beneficiaries. It is a way to maximize the amount of their estate that beneficiary heirs receive after taxes are paid.
Some people even use life insurance as a way to provide their beneficiaries with a means to pay taxes on the non liquid portions of an estate that they inherit.
Does the IRS Really Hate Life Insurance?
Ok, so the IRS may not actually hate life insurance, but for people who use it in a savvy way there are some very useful tax benefits. The IRS does miss out on the opportunity to tax a lot of money when it comes to life insurance, but tax laws are written by the government so the laws were written the way that they are on purpose.
There is after all a very important reason that life insurance enjoys it’s preferential tax treatment: it is meant to provide much needed financial protection from death. For people who use life insurance smartly to avoid taxes, the benefits can be even greater.
