Too often financial advisors and other financial professionals, including life insurance agents, make financial planning more complicated than it needs to be. Even among themselves, financial professionals and media personalities argue endlessly about best practices, planning methods, and products, as if there were a single one-size-fits-all solution for everyone.
One example of this is if life insurance can and should be used for tax-free income planning. Depending on the financial professional’s background, expertise, and method of compensation, you are bound to get a sharp division of opinions.
Nevertheless, regardless of how different financial professionals feel about if life insurance should be used for tax-free income planning, the IRS tax code does allow for this, and it is an important and legitimate option in financial planning – and particularly helpful for those interested in protection against increasing taxes and market risk. With an appropriate design and management of a cash value life insurance policy and a proper understanding of how this can work, you can decide if this is something that would be of benefit to you in your financial planning.
How you can use your life insurance for tax-free income
You pay a predetermined premium amount into a life insurance policy for a predefined number of years (with optional flexibility). This money then increases over the course of that time by the way of dividend payments, interest payments, or market gains, depending on the specific type of life insurance policy.
Once there is sufficient cash value built up, you can obtain money from your policy first by the way of withdrawals of premiums paid (until you have equaled that amount) and then by policy loans. In both cases, when you access this money you are not required to report it as income nor pay any taxes on it.
Why you are allowed to use your life insurance for tax-free income
First, you are accessing your own money that you have previously paid taxes on, which is the amount of the premiums you have already paid. Since you have already paid taxes on that money, you do not need to pay taxes on it again.
Second, once you have exhausted that amount, you are accessing the gains in your cash value account by way of a loan against your cash value and death benefit. Since you are obtaining this money by way of a loan it does not count as income and, therefore, no taxes are due.
Now, because this money is classified as a loan you are charged interest on this money. However, this borrowed amount can continue to earn interest as well, which can completely negate the loan interest charged to you and potentially even earn you more money without ever having to repay it. In fact, your loans can be repaid by the ongoing interest, dividends, or market gains your policy continues to earn.
Additionally, there is not even a requirement to pay back this loan while you are living. If properly managed, you can continue to regularly access income from your policy without ever having to pay taxes on it.
What happens to the policy loan at death?
When you die, this accumulated loan amount (including any applicable interest) will be paid off from the death benefit amount without any taxes due. Finally, the remaining death benefit amount is paid to your designated beneficiary, once again, completely tax-free.
As long as you do not let your life insurance policy lapse or surrender it, you do not have to pay taxes on money you access from it, including the money that your policy has earned in excess of the amount of premiums you paid into it. You, and your beneficiaries, also do not have to pay any taxes due on the death benefit.
In short, you can legitimately use a permanent cash value life insurance policy for both tax-free income and a tax-free death benefit.
To learn more about how permanent cash value life insurance can benefit you and to get specific policy illustrations tailored to your circumstances and preferences, contact us.