By: Roger Correa, LUTCF
The primary purpose of life insurance is to provide a death benefit to help replace lost income and protect loved ones from the financial losses that could result from the insured's death. However, life insurance — and we are referring here primarily to cash value life insurance — also offers a number of tax advantages, many of which are unique to life insurance. The tax benefits of life insurance are:
- You pay no current income tax on interest or other earnings credited to cash value. As the cash value accumulates, it is not subject to current taxation.
- You pay no income tax if you borrow cash value from the policy through loans. As a general rule, loans are treated as debts, not taxable distributions. This can give you virtually unlimited access to cash value on a tax-advantaged basis. After a sizable amount of cash value has built up, it can be borrowed against systematically to help supplement retirement income and in many cases, never pay one cent of income tax on the gain. (Several cautions regarding policy loans: First, loans are charged interest and policy loans reduce the death benefit and cash value. Second, if a policy lapses or is surrendered with an outstanding loan, and the amount of the loan plus the cash surrender value is more than the sum of premiums paid, the excess will be taxable. Third, if the policy is a modified endowment contract, the loan and interest on the loan paid from cash value may be taxable and, if you are under age 59 1/2, may also be subject to a 10% penalty tax.)
- Your beneficiaries pay no income tax on proceeds. Your beneficiaries generally receive death benefits completely free of income taxation. Therefore, a $500,000 policy delivers $500,000 in benefits with no deductions and no withholding required.
- You can avoid potential estate taxes on policy proceeds. A modest estate, seemingly below the taxable minimum of $3.5 million in 2009), can easily leap well past that point in size when insurance policy proceeds are counted. To avoid having life insurance death benefits included in your taxable estate, you can transfer ownership of the policy to another person or trust. In order to avoid estate inclusion, the policy must be transferred another person or trust more than three years before your death. Consult your tax and legal advisors regarding your particular circumstances.
Did You Know...?
There are two general categories or types of life insurance: term and cash value (permanent) insurance.
Term insurance provides "pure" insurance protection. It pays a death benefit to beneficiaries if the insured dies during the term the policy is in force. If the insured lives, the policy expires without value at the end of the term. Or, in many cases, the policy can be renewed for an additional term, though generally for a higher premium.
A cash value insurance policy is generally designed to provide long-term life insurance coverage, generally for the insured's entire life. (These policies include whole life and universal life, among others.) It features a level premium and the opportunity to accumulate cash value. Permanent life insurance is designed to help pay for the death benefit protection in the insured's later years by keeping the premiums level for the life of the policy (unlike term insurance), and assuring that death benefit protection does not become prohibitively expensive in the insured's later years. The cash value is available to the policyowner through policy loans and withdrawals1, which reduce the death benefit and cash value. The living benefits of cash value insurance also can be:
- Used to help pay for college or college loans, for a down payment on a new home, or to take advantage of a potential business opportunity1
- Used to provide tax-deferred cash value accumulation
- Used to provide tax-advantaged access to cash value if structured properly a permanent life insurance plan can provide tax-free access to the policy's cash value through a combination of loans and withdrawals 1
- Used to provide a foundation for a lifetime of financial security
1The cash value in a permanent life insurance policy is accessed through policy loans, which accrue interest at the current rate, and cash withdrawals. Loans and withdrawals will decrease the available death benefit and cash value.