NEWS & ARTICLES

Life insurance is more useful than many people realize when it comes to saving money on taxes.  This is because life insurance enjoys special tax benefits that other forms of investments do not receive.  Not only is the death benefit normally paid free of any taxes to the beneficiaries, but owners of life insurance actually receive beneficial tax treatment when they take money out of their life insurance contract.  Read on to learn how you can save on your taxes with a life insurance policy.

Passing Money To Beneficiaries Tax Free

The life insurance death benefit is usually paid tax free to the beneficiaries of the contract.  This is a huge tax benefit of life insurance, and it can save a lot of money on inheritance taxes for the people who receive the payment.  Especially with the ever-changing rules around the estate tax, many people are choosing to leave money to their children, grandchildren and other heirs through life insurance proceeds. This is especially true, but not exclusive to people who are high net worth individuals.

To facilitate this, many people will fund a whole life insurance policy with the money that they want to leave to their heirs, often buying paid up insurance.  The death benefit will always be higher than the money that they add into the contract, so they actually will leave more money to their beneficiaries than they have.  This is a much more tax efficient strategy than simply leaving money to future generations via a transfer from a will.  When money is passed on with a will, any taxable portion is subject to estate taxes.  There is always a lot of speculation that estate taxes will be increasing, so this may become even more valuable if tax increase happen.

All forms of life insurance typically have tax free death benefits, not only whole life insurance.  For instance, if a parent is leaving a large sum of money to a child through a term life insurance policy the benefit is usually tax free no matter how large the face amount of the policy is.  The ability to pass money on tax free is a big reason that many clients choose to leave money to their heirs through life insurance proceeds.

Withdrawals Take Cost Basis From Contract First

All life insurance withdrawals are taxed in a special way.  When a withdrawal is taken, the cost basis is considered to be the first money to come out of the contract.  A simple way to view cost basis is by considering it the amount of money that was put into a life insurance contract by the owner.  When the cost basis is taken first, the gain is taken last (for tax purposes the gain is taxable not the cost basis).  This makes life insurance withdrawals especially tax efficient.  But why is it an advantage to have the cost basis come out of the contract first?  Let’s compare the difference between the gain being the first money out and the cost basis being the first money to come out of an investment.

Scenario 1 -Gains Are Taxed First

Lets say a client has a regular non-qualified investment account, where gains are the first dollars taxed on liquidations and withdrawals.  Let’s say the owner has a security worth $10,000, and $5,000 of the value is gain and $5,000 of the value is the cost basis.  Let’s say the owner pays 20% in long terms gain taxes from liquidations, and he needs to receive $3,000 to pay bills after taxes are taken out.  To receive $3,000 after tax, the client will need to actually withdraw $3,750 from the contract, and $750 of the withdrawal will go to pay the 20% capital gains tax.  This leaves $6,250 in the account.  If the account earns 6% per year, it will take about 2 years of time with compounding for the value of the account to be back to the $7,000 level.

Scenario 2 -Gains Are Taxed Last

Now let’s compare a similar scenario, except this time the client is withdrawing the money from a life insurance contract (not a MEC).  The gains are taken out last, so if he has the same $5,000 cost basis with $5,000 of gains in the account he only needs to withdraw $3,000 to receive a net of $3,000 because the withdrawal is not taxable at all.

After the withdrawal, the account is left with $7,000.  Let’s say the life insurance contract pays 5% in dividend payments, or interest, or gain (depending upon the type of contract) each year.  After 2 years, the cash value will be about  $7,700.  Even if the rate of return is significantly lower, the account that is taxed cost basis first is much better off than the account where gains are taxed first, and will be for quite some time.  When you consider other benefits of life insurance such as the stable returns it is clear why many investment professionals view life insurance as a worthwhile investment.

Loans Are Tax Free

Perhaps even more significant than withdrawals being taxed “gains last”, is that loans of any amount can be taken out of the policy tax free, and they never necessarily need to be repaid.  Taxes never need to be paid on the loans, even if the loan withdrew more than the cost basis, unless the policy lapses.  As long as the owner is able to keep his policy in force, he can remove as much money as allowed by the insurance company via loans (usually about 90% of the cash value) and never pay taxes on this.

If the insured person passes away while loans are outstanding, the death benefit is still paid to beneficiaries free of taxes.  Loans allow an excellent way to access cash without incurring taxes.

Dividends Are Not Taxed

Dividends paid on participating whole life insurance policies are not taxed.  The IRS treats them as “a return of premium” for the purposes of taxation.  This means that a policy owner can get paid income for their entire life from their whole life insurance policy through dividends, and they are not liable to pay any taxes on them at all.  Using the preferential tax treatment of dividends to your advantage, especially when supplementing retirement income, is a great way to reduce the overall percentage of your income that you pay in taxes.

Dividend payments can be significantly large on whole life insurance policies that have accrued a large cash value (which they tend to do after being in force for a long period of time even if premium payments are not high). In fact some dividend payments can be large enough that a person can live off nothing but dividends, especially during retirement with a relatively low cost of living.

Life Insurance Saves On Taxes

When you consider the preferential tax treatment of the death benefit, withdrawals, loans, and dividend payments, it is clear that life insurance can be a great way to reduce your tax burden when used properly.  To get a quote on a permanent or term life insurance policy simply enter your zip code in our quoting tool and fill out our simple form.  You will then be able to compare policies from different companies to find the best policy to suit your needs.