With today’s ever-changing retirement landscape, many people want to achieve a diversified tax base — a portfolio of financial assets that offers different types of income tax advantages. Life insurance can play a role in that 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 properly structured life insurance contract can help mitigate such tax policy uncertainty in addition to the tax benefits 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 other 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 all 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.”
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 earn 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 so 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, there are no requirements to start taking minimum distributions by a certain age.
Money taken as withdrawals or partial surrenders from the cash value of a life insurance policy is 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 cash value loans from insurance policies may be more favorable than those available for personal loans.
Policyowners can withdraw or borrow against their cash value for any need, like paying a college bill or coming up with a down payment on a house.2 And, unlike most retirement accounts, there is no penalty for accessing cash value before age 59½.
This cash value feature is where a whole life insurance policy can serve as a useful tool in an overall retirement income strategy.2
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 in 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 use the cash value component of a whole life insurance policy as a ready reserve of funds for inevitable market pullbacks, allowing time for invested funds to recover. (Related: How life insurance can help you in your retirement)
“Permanent life insurance affords the insured available cash on a tax-favored basis,” said Rotman. “This pool of assets 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, taken as a tax-free withdrawal 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 part of an overall savings and investment strategy and provide for additional tax diversification of income sources.
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1 Dividends are not guaranteed.
2 Access to cash values through borrowing or partial surrenders will reduce the policy’s cash value and death benefit, increase the chance the policy will lapse, and may result in a tax liability if the policy terminates before the death of the insured. If the policy is a Modified Endowment Contract, policy loans and/or distributions are taxable to the extent of gain and are subject to a 10 percent tax penalty if the policyowner is under age 59½.