Wouldn’t it be great if there was a product that you could invest your money into and it could grow your money tax-deferred, provide you with tax-free income, and either negate or offset estate taxes? There is a product out there, but most people don’t know how it works. This product is life insurance.
Besides the financial security that life insurance can provide your family and beneficiaries, permanent life insurance can provide you with a means to reduce your tax burden while you are alive. It can also reduce or eliminate taxes that your beneficiaries would otherwise pay on your estate. We at Life Ant feel that people are if more people were aware of the tax benefits of life insurance, they would consider purchasing a policy.
We conducted a survey and found that people were largely unaware of the tax benefits of life insurance. For example, only 83% of non-owners surveyed did not know that the death benefit is usually tax-free. We also found that if people were made aware of the tax benefits, they claim to be more likely to own life insurance in the future. To help people learn how they can use life insurance to decrease their tax burden, we created this guide.
Here’s how life insurance can help you reduce what you owe in taxes during your lifetime, and how it can help your beneficiaries save on taxes too.
Only 15% of people who don’t own life insurance knew that the cash value will grow tax-deferred. Normally you can only get tax-deferred growth inside a retirement account like an IRA or 401(K). This can make life insurance an excellent source of retirement savings, yet few people tap into this resource.
If you invest your money into a permanent life insurance policy, that money will grow completely tax deferred. Instead of paying capital gains taxes each time you rebalance your portfolio with a non-qualified investment account, consider a variable universal life insurance policy instead. You can make trades or rebalance as often as you like without any tax consequences, as long as the money stays within the policy.
Whole life insurance and variable universal life insurance also grow completely tax deferred. Any interest earned as a part of the annual increase in your whole life insurance cash account cannot be taxed unless you remove a large enough sum from the policy such that the gains are withdrawn. No matter how large or how fast your holdings grow, you have no obligation to the IRS until you take the money out. When you do decide to take the money out, there are more advantages compared to non-qualified accounts.
While 22% of the people surveyed who are life insurance owners did know that cash value grows tax-deferred, this is still a staggeringly low proportion of people. Perhaps if more people knew how to take advantage of the products they already own our nation would not face such a retirement crisis.
Tax Benefits To Withdrawals And Loans
You have the option to take money out of your life insurance policy whenever you wish. You may take loans, withdrawals, or surrender the policy completely for the cash value. When you take money out of a life insurance policy there are more distinct tax advantages.
As long as your policy is not a modified endowment contract (MEC), your cost basis is considered the first money out for tax purposes. You may remove an amount equal to the total premiums that you paid into the life insurance policy, and not pay taxes on any of it.
You can also access the cash within your policy via a loan. A loan does not need to ever be paid back, and as long as you are within the life insurance companies allowable loan amounts a loan is not taxable. Loans are a great way to access the value in your life insurance policy completely tax-free while you are still living and still leave your beneficiaries the death benefit.
Dividends Are Tax-Free
According to our survey, only 9% of non-life insurance owners know that dividends from life insurance policies are paid mostly tax-free.
Life insurance dividends are not taxed like stock dividends. Instead of being taxable, life insurance dividends are considered by the IRS to be a return of premium. You can collect life insurance dividends up to an amount equal to your total premiums paid without paying any taxes on the income whatsoever. Taking your dividends as a cash payment does not necessarily affect your death benefit or reduce your life insurance either.
During retirement, life insurance dividends can be a great way to supplement your social security earnings without increasing your taxes. Even before retirement life insurance dividends can provide a steady stream of income that will not increase your income taxes.
To illustrate how much of an advantage this is, consider a life insurance policy paying $2,500 per year in tax-free dividends to the owner. Because there are no taxes, the $2,500 in payments results in $2,500 of usable income.
Now compare the consequences of the same owner instead of receiving taxable dividend payments from stocks. If we assume the owner is in a tax bracket where he pays 20% income tax on dividends, for the owner to receive $2,500 of income he will need to earn $3,125 in payments. This means that $625 are paid directly to the IRS in taxes each year and over a 20 year period, this is a not insignificant sum of $12,500 paid in taxes. By collecting dividends from life insurance instead of from stock dividends, owners can save a lot of money.
Even owners of life insurance weren’t much more aware than nonowners when it comes to knowledge about dividend taxation. Only 18% knew that life insurance dividends are not taxable. This is likely because most people surveyed did not own participating policies that pay dividends, or if they do they use them to offset premiums or reinvest them back into the policy. Perhaps financial advisors should do a better job of educating their clients about dividends.
The Death Benefit Is Usually Tax-Free
Perhaps the biggest tax benefit of life insurance is the tax-free death benefit. Even among owners, only 29% realize that their death benefit is paid tax-free! This shows just how uneducated people are about even the products that they own.
Under most circumstances, life insurance claim proceeds are paid to beneficiaries without any taxes. This provides a very tax efficient way for people to pass large sums of money to their children and families.
People with large estates often use life insurance as a way to avoid the estate tax, including the use of a trust specifically for life insurance. Instead of passing money to their beneficiaries they instead fund a life insurance policy. This allows them to pass a greater or equivalent amount on without any estate taxes. Anyone interested in this should talk to an estate attorney because the ownership of the contract may need to be structured in a certain way, such as through an irrevocable life insurance trust.
People also use life insurance as a way to pay estate taxes on items outside of a trust or to make an estate that does not divide up to multiple equal portions very easily equitable for all beneficiaries. An example is a valuable home. Because you can not split a large item between people, and making multiple people beneficiaries of one item is often not practical, a life insurance policy could provide the approximate equivalent value of the home to another beneficiary in order to make the inheritance equitable for all. It may also be most efficient to use life insurance as a means for a beneficiary to pay for estate taxes on an item like a home that they inherit but otherwise may not be able to pay the tax on without selling.
Use Life Insurance To Lower Your Taxes
Life insurance provides unique tax benefits to many people. People can grow their cash value within a policy without tax consequences, and then access their money through loans, withdrawals, and dividends with tax-preferred treatment. You can also avoid or offset estate tax with a tax-free death benefit unique to life insurance. Based on the results of our survey, there is a clear need for more education about how life insurance is taxed. Perhaps more people would own this product which is so crucial to protecting their families financial security, and more people may be able to save on taxes if they do.
If you are looking to reduce your tax burden, you should consider using life insurance as a vehicle to accomplish this.