With today’s ever-changing retirement landscape, many people want a portfolio of financial assets that offer different types of income tax advantages. Life insurance can play a role in that tax-benefit strategy.
“We are entering into an era of possible tax changes,” said Doug Collins, financial planning director at Fortis Lux Financial in New York City. “Many things are on the table, including higher capital gains taxes and a reduction in the estate tax exemption. A life insurance policy can provide access to cash value that can help support income needs, when other assets may be impacted by tax policy changes in addition to the tax advantages life insurance has historically provided.”
Of course, life insurance is first and foremost about protection — helping loved ones carry on in the event of an untimely passing. (Calculator: How much life insurance do I need?)
But some types of permanent life insurance, such as whole life insurance, have tax-advantaged features that can complement retirement savings vehicles.
“A critical component in retirement planning that tends to be overlooked is tax planning,” noted Jeffrey R. Rotman, a wealth management advisor at Rotman and Associates in Boca Raton, Florida. “Most assets for retirement are parked in retirement accounts, such as 401(k)s, IRAs and SEPs. These are generally taxed as ordinary income in retirement. And as retirees, we lose many deductions, such as saving on a before-tax basis, claiming children as dependents, and not having the home paid off, all of which could be significant from a tax perspective. All this makes diversification of retirement income streams critical.”
Life insurance benefit: Tax-deferred accumulation
Permanent life insurance builds cash value over time.
- In the case of whole life insurance, the cash value grows at a rate guaranteed by the insurance company.
- Other types, like variable universal life insurance, can earn returns based on the performance of investment accounts.
Additionally, some life insurance policies are eligible to receive dividends, which can add to the life insurance protection and cash value as well.1
Cash value grows on a tax-deferred basis, which means the question of taxes doesn’t come up until the value is accessed. How fast it grows depends on the premium plan involved.
For instance, some whole life insurance policies can be paid up with as few as 10 premium payments, and consequently build cash value relatively quickly. Of course, the premiums for such a policy are substantially larger compared with other whole life insurance policies that extend premium payments over a longer period. Some policies, for example, spread premiums over the time it would take for a policyowner to reach an age of 100. That type of pay-to-age-100 policy has smaller premiums than a 10-pay policy, but builds cash value at a slower pace. (Related: What premium plan is right for me?)
Unlike qualified retirement savings programs, such as a 401(k) or IRA that have minimum distribution requirements, a whole life policyowner can access available cash value at any time.
Life insurance benefit: Tax-advantaged access
Distributions taken from the cash or account value of a permanent life insurance policy are not subject to taxes up to the “cost basis.” That’s the amount paid into the policy through out-of-pocket premiums. It doesn’t include any of the tax-deferred investment gains or dividend additions the policy may have had.1 And interest rates on loans from insurance policies may be more favorable than those available for personal loans.
Policyowners can take distributions or borrow against their available cash or account value for any need, like paying a college bill or coming up with a down payment on a house And, there is no penalty for accessing cash value before age 59½.2
This cash value feature is where a whole life insurance policy can serve as a useful tool in an overall retirement income strategy.
Many people rely on savings built over time and typically invested in equity markets to provide income in retirement. When markets go into retreat, it can present challenges for retirees. Taking money from a retirement account following a declining year can have a negative impact on the long-term value of the account. In particular, one or two years of negative returns early on in retirement can have a significant and damaging effect on the ability to continue withdrawing the same level of income in later retirement years.
Retirees can access the available cash value of a whole life insurance policy for inevitable market pullbacks, allowing time for invested funds to recover. (Related: How life insurance can help you in your retirement)
“Permanent life insurance can afford the insured available cash value on a tax-favored basis,” said Rotman. “Life insurance can be utilized as a buffer from stock market conditions, a reserve for out-of-pocket medical copays and prescriptions, long-term care needs, and a supplement to retirement income.”
Social Security options
Additionally, by taking partial surrenders of the cash value of their whole life insurance policies first, retirees can possibly delay the need to begin taking Social Security payments. And Social Security benefits increase the longer one waits to receive them. (Related: Filing for Social Security retirement benefits)
Also, income from a life insurance policy up to cost basis, taken as an income tax-free distribution or loan, is not included in the income calculation for taxes on Social Security benefits.
Of course, all the features above are ancillary to the primary purpose of life insurance: protection for loved ones. But there, too, is a financial benefit: Life insurance death benefit proceeds are generally income tax free. (Related: 3 tax advantages of life insurance)
“The legacy of a tax-free death benefit can provide the permission slip to spend other assets in retirement without impeding your legacy intentions,” said Rotman.
This protection, combined with accumulation and access features, make whole life insurance a useful option as a complement to an overall savings and investment strategy and provide for additional tax diversification of income sources.
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This article was originally published in October 2021. It has been updated.