Proper tax planning can help with two important goals—reduce your taxes while you are alive, as well as after you die. Permanent life insurance gives you the potential to cover these two bases at once, where you build up cash value that you can tap into tax-free while alive and then create an income-tax-free inheritance for your loved ones after you pass away. Here are the ways to cut your tax bill with permanent life insurance.
Key Takeaways
- Life insurance allows you to transfer a death benefit to beneficiaries income tax-free.
- While estate taxes can apply to life insurance, there are strategies to avoid these taxes.
- Permanent life insurance also builds cash value you can use while alive.
- Cash value grows tax-free while in your policy.
- If you withdraw cash value, you owe income taxes on gains. However, loans let you access the money tax-free.
Your Beneficiaries
When people think about life insurance, they generally envision how it will help those they leave behind. So first, let's talk about what life insurance does for your family. If you pass away, the death benefit can pay for a child's future college education, provide a retirement fund for your spouse, or simply make sure your survivors have the money to live the lifestyle you want for them.
The life insurance death benefit is completely income-tax-free to beneficiaries. No matter how big the death benefit is—$50,000 or $50 million—your beneficiaries won't pay a single cent of income tax on the money they get.
This is not true for most other financial accounts. For instance, beneficiaries can get walloped by the Internal Revenue Service (IRS) when they inherit individual retirement accounts (IRAs), tax-deferred annuities, and qualified retirement plans. They could end up losing up to $0.35 out of every dollar you leave them to federal income tax. Life insurance creates a more tax-effective inheritance.
Estate taxes could apply to life insurance death benefits. However, the estate tax exemption is very high. At the federal level, you can transfer millions of property at death, including the death benefit of your life insurance policies. If you think you might face the estate tax, there are also strategies you can use while alive to avoid the hit, explained below.
Cash Value Tax Benefits
Permanent life insurance can build cash value, a reserve of money you can access while alive. This is money that you could use to supplement your retirement income, pay for medical care, or use as an emergency fund. Cash value grows tax-deferred. You don't owe income tax as long as the money stays in your policy.
You can withdraw up to your premium payments tax-free. If you withdraw more than that, you do owe income tax on your gains above what you paid. However, you can also access your cash value through a loan. If you borrow it this way, you do not owe income tax for taking out your gains. This can keep you in a lower tax bracket in retirement and prevent taxes on Social Security.
You do not ever have to pay back the loan while alive. If you pass away with an outstanding loan, the death benefit pays it off, and then your heirs receive the remainder income-tax-free. The drawback to a cash value loan is that the insurer will charge interest. If the size of your loan plus interest exceeds your total cash value, you would need to pay more into the policy or else it will lapse.
Investment Tax Benefits While Alive
Asset Allocation
There are several versions of permanent life insurance. Some, such as universal life (UL), pay a fixed interest rate on the cash within the policy. Others, however, such as variable universal life (VUL), offer dozens of investment options. These might include a large-cap stock fund, an international stock fund, a bond fund, or even a real estate fund. The list is nearly endless.
The growth of the cash value in VUL is determined by the performance of the underlying portfolio(s) chosen by you. This becomes part of your total investment portfolio. Reallocations within the policy are not taxable. So when it comes time to rebalance your investments, you won't have to worry about paying income tax on profits you take as you make changes in the VUL. Your investments also grow tax-deferred, the same as any other cash value options.
Maxed-out Retirement Plans
If you already contributed the maximum amount to your 401(k) and IRA this year, permanent life insurance could help you save more. There are no restrictions on how much you can put into permanent life insurance. It's another way to access tax-deferred growth after you've maxed out your retirement plans.
In addition, there are no income restrictions for using permanent life insurance, like on a Roth IRA. You can use this tax-deferred investment strategy no matter how much you earn.
Strategies for Taxes on Death Benefits
Give It Away Now
If you would like to see your money working for your heirs while you're still alive, as well as increase the amount they'll receive when you die, then you might want to consider giving cash to them today. For the greatest benefit, your heirs can use part of the gift to buy a life insurance policy on your life. Meanwhile, you'll be able to watch your loved ones enjoy the remainder of the money—right now.
What's more, you'll reduce your taxable estate by the amount of your gift. And, because your loved ones are the owners and beneficiaries of the policy, they won't have to worry about estate or income taxes on the death benefit when you die. They also won't have to worry about paying income taxes on the growth of the life insurance cash value as long as they keep it in the policy.
Irrevocable Life Insurance Trusts
Another option for higher net worth individuals is an irrevocable life insurance trust (ILIT) that purchases the insurance policy directly, so as to exclude it from one's personal estate. You make a cash gift to the ILIT to purchase a permanent survivorship life insurance policy. The ILIT is the owner and beneficiary of the policy. When the survivor dies, your heirs will not have to pay estate and income taxes on the death benefits.
FAQs
Is Permanent Life Insurance Tax Deductible?
Permanent life insurance is not tax deductible if you buy a policy for yourself or another family member. A business owner could tax deduct the cost of premiums to pay for life insurance for employees. Most people do not receive a tax break when paying for life insurance though.
How Can I Use Whole Life to Avoid Taxes?
Whole life insurance can avoid taxes by building cash value. Your cash value savings grow tax-deferred, so you don't owe income tax as long as you leave the money in your account. In comparison, if you saved through a savings account or a bank Certificate of Deposit, you'd owe tax on your interest each year. If you borrow your whole life insurance cash value through a loan, you can take the money out without owing taxes.
Is Permanent Life Insurance Tax-Free?
Permanent life insurance is mostly tax-free. When you die, your heirs do not owe income tax on the death benefit. Estate taxes apply, but the limit is so high that few people owe this tax. Permanent life insurance also grows tax-free. You only owe income tax on your cash value gains if you withdraw them or if you cancel the policy.
Bottom Line
If income and estate taxes keep you awake at night, life insurance might be the answer. Permanent life insurance is one of the most powerful tax planning tools you can find. It offers several unique ways to address your estate tax and income tax liabilities both while you're alive and for your heirs after you pass away.
