By Brad Cummins
Learn more about Brad on NerdWallet’s Ask An Advisor
While most people may look at life insurance proceeds simply as a way to pay off debt or to replace the insured’s income, there are tax-related benefits that can make life insurance policies a viable planning tool in other areas of your finances.
Certainly, one of the primary advantages of life insurance is that death benefit proceeds go to the beneficiary income tax-free. This means the recipient of the funds can make full use of the money for paying off debt, replacing lost income or meeting other important needs during a difficult time.
Although term life insurance provides only pure death benefit protection, permanent life insurance is a different story. Permanent life insurance policies provide death benefit coverage plus a cash-value component that can allow the policyholder to build up a substantial amount of tax-deferred savings over time. As an independent life insurance agent, I have worked with clients who incorporated some of these tax-advantaged features into their planning in a variety of ways.
There are several types of permanent life insurance policies available in the market today. These include whole life, universal life, variable life, variable universal life and indexed universal life insurance.
The tax-related advantages available to the permanent life policyholder during life include:
- Tax-deferred growth
With permanent life insurance policies, the gain in the cash value is not taxed until it is withdrawn. This means that the funds are essentially able to obtain gains on top of gains, year after year, allowing the money to grow substantially over time. When the policyholder does make a withdrawal, the gains are taxed as ordinary income.
If you don’t harvest the cash value before death, however, you risk the chance that the cash value — including the policy’s dividends — will be absorbed by the insurance company and only the death benefit will be paid out to the beneficiary.
- Tax-free dividends
In many cases, the dividends received on eligible life insurance policies are also tax-free and do not have to be reported on the policyholder’s tax return. This is because dividends are considered a return of policy premiums. It is important to note, though, that dividends could become taxable if they start to exceed the net amount of premium that has been paid into the policy. Often policy dividends can be used for paying the policy’s premiums and/or for purchasing additional amounts of insurance.
Upon the death of the insured, the cash value, including the policy’s dividends, is absorbed by the insurance company, and the policy’s death benefit is paid out free of income tax to the beneficiary. (It is important to note that the death benefit amount may still be included in the insured’s overall estate value and therefore included in his or her estate tax calculation.)
- Cash withdrawals
You can take cash back out of the policy if it has sufficient cash value. A withdrawal will generally be tax-free, up to the amount of the policyholder’s “basis” in the plan; the basis is the amount of money that has been deposited into the policy via the premium payments. Any amount above that basis is considered to be gain — and gain is subject to ordinary income tax upon withdrawal.
Withdrawals are typically treated as coming out of the policy’s basis first, and then the gain. As an example, if the cash value totals $15,000, and $10,000 of that is basis, then the first $10,000 withdrawn would be tax-free. Any amount withdrawn above that would be considered gain and therefore taxable income.
In order to access a cash withdrawal, it is typically necessary to contact the insurance company directly.
In a cash surrender you simultaneously take out the cash value and cancel your policy, but there may be what’s called a surrender fee involved, even if only basis is being taken out. The amount of the surrender charge will often depend on how long the policyholder has owned the policy. One way to avoid a surrender charge is to borrow the money using a policy loan (described below) or by withdrawal rather than surrendering the policy.
- Policy loans
The cash value in a permanent life insurance policy may also be used as security for a policy loan. As long as you repay the loan, you’re not wiping out the coverage provided by the policy, because you’re only working with the cash value. When a policyholder borrowers against the cash value in a permanent policy, it is not considered a distribution and so is not counted as income to the policyholder.
There are no taxes due on life insurance policy loans and no surrender charges because the policyholder is not technically withdrawing any money. However, there will be interest charged on the loan and the interest is not tax deductible. The interest rate varies, but it’s typically lower than what you will find on loans from banks and other lenders.
For these reasons it can make sense in some situations to take a policy loan — to pay off high-interest debt obligations, for instance, or when you really need cash and are not able to qualify for a standard loan from a lender — provided that you can pay off the policy’s loan. But be careful, because any amount of unpaid policy loan at the time of the insured’s death will be subtracted from the death benefit that is paid to the policy’s beneficiary.
Obtaining a policy loan will usually require contacting the insurance company directly.
Smart planning tool
Because of the numerous tax advantages available on cash-value life insurance policies, some individuals can use them as tools in areas of financial planning, such as supplementing retirement income, paying off large debt like a mortgage, and funding a child or grandchild’s college education.
For example, today, many retirees are using their life insurance cash values to fill in the income gap that may be left when the funds from their retirement accounts and Social Security do not cover all of their expenses in retirement. In this case, funds from a policy loan can be especially beneficial as they are received income tax-free.
In addition, for those who may be retiring early (prior to age 59½), there are no early withdrawal penalties for removing funds from a life insurance policy, unlike with IRAs and other retirement accounts. Likewise, there are no required minimum distribution rules for leaving funds in such policies past age 70½, as there are with many qualified retirement plans and traditional IRAs.
Permanent life insurance goes beyond just paying a death benefit, but you may pay more for the additional features. Make sure you understand the terms of your contract so you get the best insurance for your needs.
Looking beyond the help tax-free death benefits can provide for your family when you are no longer here, there are additional advantages to this type of insurance that could be useful while you are still alive. An understanding of these other features combined with smart planning can help make sure you come up with the best solution to fit your overall coverage and savings needs.