Most people probably don’t consider their life insurance policies when tax season rolls around. Perhaps they should.
Life insurance, in particular whole life insurance, can help you and your beneficiaries avoid a hefty bill from the tax man.
The advantages outlined here are particular to permanent life insurance, including whole life insurance policies. It’s possible for other kinds of insurance to have some of these features as well… but it’s not a given.
- 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.
- The total cash value accumulates on a tax-deferred basis.
Whole life insurance builds up cash value over time as you pay premiums. This is money that grows without the IRS taking a current bite. And the accumulated funds can be important in the future.
- 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 in 1980.
There are a couple of ways that Steve could access his policy cash value during retirement:
- First, 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 your Lenox Advisor about your particular situation.