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The tax benefits of life insurance

 
There’s an old saying that the only things we can be certain of in life are death and taxes. Not a pleasant choice, for sure. But most people generally accept the inevitability of both. What choice do we have? Yet, ironically, aside from the certainty of life’s two least anticipated events, there is another connection they share. There is one way for people to protect themselves from both. Life insurance.
 
Yes, life insurance.
 
When most people think of the benefits of life insurance they imagine their spouse and children having the money they need to carry on after their death. And while that’s the primary reason people buy life insurance, permanent life insurance like whole life, universal life, variable life, and others also offer a number of potentially valuable tax benefits.
 
So, the right policy can not only protect a family’s finances from loss decades from now, but it can also protect their finances from taxes, too.
 

How life insurance reduces your taxes.

From providing tax-free death benefits to building tax-deferred value, life insurance offers countless tax benefits. So many that it’s easy to see why some people view it as a valuable financial planning tool. Now, there are a few instances when life insurance is taxable, but these situations are the exception, not the rule. At most, they only ever affect a tiny percentage of policyholders, which we’ll point out as we go.
 
So, let’s review all the tax benefits that life insurance offers.
 
Death Benefits. The first question most people ask is, are life insurance benefits taxable? The short answer is no. When a policyholder dies, the beneficiaries receive the death benefit free of income taxes. There’s a reason for that. It’s because the IRS considers the death benefit reimbursement for a loss, rather than income. So, beneficiaries get the full amount available under the policy. Way to go IRS!
 
Spousal payments. With very large estates, life insurance death benefits can sometimes be taxable. However, when the beneficiary is a spouse, there are no federal income taxes or estate taxes, regardless of how large the estate may be. That’s because the IRS created an unlimited marital deduction, exempting death benefits paid to a spouse.
 
Tax-deferred growth. When you pay your life insurance premiums on a permanent policy, the insurance company invests that money. Over time those investments increase, and the policy builds cash value. Now the good part is that none of those gains are subject to tax. Just another of the tax benefits of life insurance. As long as they remain inside the policy, your gains will continue to compound year after year, with the potential for the money to grow substantially. Once the policy is surrendered or lapses, then the gains are taxed.
 
Dividends. Mutual insurance companies, which are owned by policyholders, often pay annual dividends to policyholders. Because the IRS sees these dividends as a return of your premiums, rather than income, you do not have to pay income taxes on your dividends. (Of course, there’s a “but”). But, if the dividends you get paid in any year exceed the premiums you paid, they you may need to pay taxes on the difference. Then again, your premiums were effectively free that year.
 
Wealth transfer. If you happen to have an estate worth over $5.45 million as of 2016, good for you. But, you also know that an estate that large will be subject to the estate tax when you die. So, your heirs will have to fork over a pretty hefty chunk to the IRS. But, as we mentioned earlier, death benefits are not subject to income taxes, whether $100,000 or $10,000,000. So, life insurance can be a pretty smart way to transfer money to the next generation while helping your heirs avoid the taxes.
 
Now, in very rare instances, the death benefit may be taxable if the estate is extremely large. Then you could set up an irrevocable trust to receive the death benefit and avoid the taxes altogether. But that’s a conversation you’ll want to have with your financial advisor. Either way, life insurance represents a pretty significant tax-free way to transfer wealth to your children, grandchildren, or even favorite charities.
 
Cash withdrawals. Need money? Good news. You can withdraw cash from your life insurance policy up to the amount you’ve paid in premiums without paying taxes on the money. Why? Again, because according to the IRS, the money you’re withdrawing is simply a return of the premiums you already paid, so the IRS doesn’t consider it income. We’re starting to like the IRS.
 
Policy loans. Another way to take money out of your permanent life insurance policy is by borrowing against its cash value. As long as you pay the money back, you won’t pay income taxes. That’s true even if you borrow way more than the premiums you’ve paid. That’s because a loan isn’t considered a distribution, so it’s not counted as income. The IRS really thinks about this stuff, don’t they? But be sure to pay the money back. If you die and there’s an outstanding loan against your life insurance policy, the balance will be deducted from the death benefit, and could be subject to taxes. Ouch.
 
Surrender payouts. If you decide you no longer want your permanent life insurance policy, you can “surrender” it and receive a lump sum. The payout you receive will be a combination of the premiums you’ve paid over the years and the gain in cash value.
 
Depending on how long you held the policy, it could be a nice chunk of change. As with previous examples, because you paid money into the policy as premiums, this money is being returned to you, so you’ll pay no income taxes on it. You only pay taxes on the gain. Say you paid $40,000 in premiums but receive a total of $60,000 in cash value. You’d pay income taxes only on the $20,000 gain. But that’s true of any profit, right?
 
Exchanging for an annuity. One of the least known – and perhaps most valuable – advantages of permanent life insurance is the ability to exchange the entire cash value of the policy for an annuity, with no taxes on the gains. It’s one of the more interesting tax benefits of life insurance. An annuity is a contract between an individual and an insurance company where the insurance company pays the individual an annual income for the rest of the individual’s life in exchange for a specified payment upfront. Not a bad deal all around.
 
Transferring ownership. Another interesting way to avoid estate taxes is to transfer ownership of a life insurance policy so it’s not counted as part of your estate. If you have a single-premium policy, where you paid all the premiums at once, upfront, the new owner will be subject to gift taxes, but those are far less than estate taxes.
 
Let’s say Bob Sr. transfers ownership of his policy to Bob Jr., and it has a cash value of $50,000. Bob Jr. is going to owe income taxes on $36,000 since gift taxes kick in on any gift over $14,000 in a single year. Now, suppose Bob Sr. had transferred to Bob Jr. a permanent policy that still had annual premiums, and gave Bob Jr. $14,000 a year to pay the premiums. Guess what? No gift taxes! And, when Bob Sr. passes away, the life insurance is not counted as part of the estate Bob Sr. leaves behind. So, Bob Jr. pays less in estate taxes too. Nice going, Bobs!
 
Retirement income. Because of all the ways people can take money from permanent life insurance policies – and the tax advantages – many retirees often use the cash value to fill in any income gaps they may encounter. They can withdraw cash or take a policy loan without worrying about income taxes or required minimum distribution rules as with traditional IRAs.
 

The bottom line.

We know. That was a lot. But once you’ve seen the financial and tax advantages permanent life insurance policies offer, it’s hard to think of them as financial protection alone. Structured correctly, a permanent life insurance policy allows you to provide a tax-free financial cushion for your family, build wealth, transfer wealth to your heirs, and more.
 
So maybe death and taxes aren’t the only two things that are certain in life. Maybe we can avoid at least one of them. That’s just one of the benefits of life insurance. And that’s not bad.