Most people probably don’t consider their life insurance policies when tax season rolls around. Perhaps they should.
Of course, life insurance's primary function is to help protect loved ones in the event of your passing. But life insurance, in particular whole life insurance, can also help you and your beneficiaries manage tax consequences to a certain degree.
The three advantages outlined here apply to whole life insurance and other permanent insurance policies. The first one applies to term life insurance policies as well. (Learn more about different types of insurance)
1. The death benefit is generally paid out income tax free.
That’s a pretty straightforward advantage for your beneficiaries. Life insurance policy payouts can be pretty hefty and avoiding a major tax bite can be consequential. By contrast, the government will typically tax most retirement plan proceeds when taken by beneficiaries.
There are instances where federal and state estate taxes can kick in on the proceeds of a life insurance payout, depending on particular circumstances. If your life insurance policy is part of a large estate, talking to a financial professional might be worthwhile.
2. The total cash value accumulates on a tax-deferred basis.
Permanent life insurance builds up cash value over time as you pay premiums. In the case of whole life insurance, the cash value grows at a rate guaranteed by the carrier that isn’t affected by market conditions. Other types of permanent insurance allow for different investment options.
The growth in cash value is on a tax-deferred basis, meaning this is money that grows without the IRS taking a bite. And it can become an important nest egg for your future. (Related: Whole life insurance: Balancing protection and accumulation)
3. You can access the cash value of the policy on a tax-advantaged basis.
Money borrowed or taken from the cash value of a life insurance policy is not subject to taxes up to the “cost basis” – the amount paid into the policy through premiums.
To understand how this works, take a hypothetical case of “Steve,” who bought a whole life policy, say, 25 years ago.
There are a couple of ways that Steve could access his policy cash value during retirement:
- First, in our hypothetical example, he has a cost basis in his policy of $132,840 (the total premiums that he paid). He could take a partial surrender of the cash value from his policy up to this amount, and it would be income-tax free.
- In addition, Steve has the option to borrow against his cash value at any time. The amount borrowed will not be taxable as income, even if it is in excess of his cost basis.
Careful, though. A certain class of policies receives less favorable tax treatment than what is described above when taking loans and distributions and may be subject to a penalty tax.
Also, tapping into the cash value of a life insurance policy reduces its value and death benefit and increases the chance the policy will lapse. And if a policy lapses with an outstanding loan in excess of the cost basis, it’s taxable.
Again, if you are thinking of taking a distribution it might be worth checking in with a financial professional about your particular situation.
To see how much life insurance you might need, use our calculator.
Beyond these three advantages is another consideration. Retirement rules and distribution requirements are in a state of flux these days. Many people want to create a portfolio of financial assets that offers different types of income tax advantages. Life insurance can play a role in that strategy. (Related: How whole life insurance helps diversify your taxes)
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