Cash value life insurance has the uncommon distinction among financial products of being both predictable and versatile.
With whole life, for instance, premiums, growth rates, and death benefits are all guaranteed. This means that you can predict with a reasonable level of certainty the cost of the policy, the rate at which its cash value will grow over time, and the amount of liquidity that the policy will infuse into your estate or pay out to your designated beneficiary.
This kind of certainty is exceptionally useful in developing an estate or retirement plan or a strategy to ensure the continuity of your business.
Jump To A Section
- Are Life Insurance Proceeds Taxable?
- Is Cash Value Growth Taxable?
- Taxes When Surrendering Policy
- Are Cash Withdrawals Taxable?
- 1035 Exchange Taxes
- Additional Benefits
The chief alternate to whole life and other cash-value policies, term life insurance, can be useful under the right circumstances but cannot offer the same level of predictability.
Although the premiums may be fixed, death benefits are only guaranteed during the policy’s term, so a term policy cannot be relied upon for estate liquidity.
And term life has no cash value, so it does not grow and does not provide any benefits useful for retirement planning.
Whole Life Versatility
On the other hand, whole life’s versatility makes it highly valuable in retirement and estate planning.
If you need guaranteed cash at death – whether to pay estate and final income taxes, fund inheritances, endow a favored charity, or fund a testamentary trust – cash value insurance can reliably provide the necessary liquidity.
Or, if you reach a point where death benefits are less important and you would rather have extra income for retirement, you can annuitize a whole life policy and receive regular payments from the insurance company for the rest of your life.
If you prefer a lump sum, a whole life policy can be surrendered for cash.
If you still want a death benefit but want to remove the premium payments from your retirement budget, a reduced paid-up option let’s you decrease the eventual pay-out in exchange for eliminating any further obligation to pay premiums.
The options for leveraging a whole life or other permanent policy are seemingly endless when you also consider the assortment of riders available to customize a policy to personal needs and preferences.
But there’s an advantage of cash-value life insurance that is unfortunately often overlooked – favorable tax treatment.
Both on the front end (in the form of tax-advantaged growth) and the back-end (in the form of untaxed death benefits), life insurance receives friendly treatment in the Internal Revenue Code (“I.R.C.”).
So with that in mind, let’s get to it, starting with the most popular question, “Are life insurance proceeds taxable?”
Death benefits are the amounts paid out by the insurance company to the policy’s designated beneficiary upon the death of the insured individual.
Because life insurance proceeds are not “income,” death benefits are not taxable income to the beneficiary.
This is the case with both term and cash-value life insurance and regardless of whether the beneficiary is a third party, the insured’s estate, or a trust.
A limited exception is when the beneficiary elects to annuitize (receive over an extended period) the policy’s death benefits.
In that event, the face value of the death benefit is still untaxed, but additional interest accruing over the extended payment term will be taxed when the interest is received by the beneficiary.
With regard to estate taxes, policy proceeds may be included within the insured’s taxable estate if the insured retained any “incidents of ownership” in the policy.
Incidents of ownership essentially mean the right to make policy changes (like amending the beneficiary designation) or to access the policy’s cash value.
As of 2019, the estate tax exemption stands at $11.4 million, so the question is purely academic for the vast majority of estates.
For estates large enough to qualify for the estate tax, it is avoidable without much trouble by designating a spouse or other trusted third party as the legal owner of the policy.
Alternatively, an irrevocable life insurance trust (ILIT) is a fairly straight-forward way to keep life insurance proceeds outside of the insured’s taxable estate.
Policy growth refers to the amount of cash value the policy accrues beyond the premiums paid to the insurance company.
Cash value also includes premium accumulation, but growth is specifically the interest paid by the insurance company.
With a fixed whole-life policy, growth accrues at a pre-defined, guaranteed rate.
Variable life policies accrue according to the performance of investments selected by the policyowner from a basket of options offered by the insurer.
Indexed universal life policies accrue growth at rates tied to the performance of a major stock index, typically with a floor and/or cap on annual growth.
401K or IRA
Similar to an IRA or 401k retirement account, growth within a cash-value life insurance policy is “tax-deferred.”
Tax-deferred growth means no income tax is owed on the appreciation unless and until it is actually received. This allows the policy to grow at a greater rate because no funds need to be pulled away from the policy to cover current taxes; the money continues growing instead.
Many participating life insurance policies receive consistent dividend payments from the insurer in addition to the regular policy growth.
Life insurance dividends are basically a portion of the company’s yearly profits paid out to policyholders, who can then reinvest the dividends back into the policy, hold the money in an account with the company, or accept a cash payment.
In the eyes of the IRS, dividend payments are “return of premium” (i.e., the insurer giving back money you paid in), and so no income taxes are owed on dividends, even if you choose to accept the money in cash.
When you surrender a permanent policy, you are trading the right to receive a future death benefit in exchange for a lump-sum check from the insurance company representing the policy’s cash value.
The extent to which the pay-out is taxable depends upon the proportion of cash value consisting of premiums versus growth. The portion attributable to premium payments is the equivalent of principal and is not taxed. The portion attributable to growth is taxable income.
Stated another way, your “basis” in a policy is the total premiums you have paid less any dividends received back from the insurance company.
(Remember, dividends are considered non-taxable “return of premium,” so when you get a dividend payment, the IRS treats it as the insurer giving you some of your premiums back).
The taxable portion of a cash-value surrender is the total payment received minus basis. I.R.C. §72(e)(5). So, for instance, if you have paid $16,000 in total premiums, received $1,000 back in the form of dividends, and get a check from the insurer for $20,000, the taxable amount is $5,000.
Qualified Retirement Plans
It’s worth noting that permanent life insurance can be purchased through some qualified retirement plans (but not IRAs) using pretax money to pay premiums.
In the case of a “qualified” policy along these lines, the “return of premium” portion of a cash-value payment received from the insurer is also taxable, along with the growth, because the premium money was never taxed to begin with.
The tax rules and requirements relating to qualified policies are complicated, and the policies have limited portability if the insured withdraws from the plan, so qualified life insurance policies have become fairly uncommon, and only a few insurers still issue them.
Partial cash-value withdrawals are taxed using the same formula for calculating basis as a policy surrender – premium amounts are untaxed and growth is ordinary income.
Since a partial withdrawal involves less than the full cash value, the question becomes ‘what money comes out first: premiums or growth?’
To answer this question, the IRS helpfully applies FIFO (“first in, first out”) accounting principles. This means that the IRS will assume that premium payments are paid out first, followed by growth.
This tax treatment is especially helpful to retirees who want to access some cash value but keep the policy and eventual death benefits otherwise intact.
Whether the money comes in the form of a pure withdrawal or a policy loan, the IRS considers all cash-value payments as non-taxable until the policy’s full basis has been received back in cash.
The eventual death benefits will be reduced for partial withdrawals or unpaid policy loans, but, when the death benefits are paid out, the funds (including growth) will not be taxable income to the beneficiary.
The FIFO rule is reversed for Modified Endowment Contracts (“MEC”). A MEC is a permanent life insurance policy that no longer qualifies for certain tax advantages afforded to life insurance because premium contributions have exceeded the limit established by the I.R.C.
Withdrawals from an MEC are taxed under LIFO (last in, first out) principles, which means the IRS assumes taxable growth is paid out first.
Due to the LIFO treatment, MEC’s are not as attractive for individuals planning to access cash-value during life.
However, death benefits and cash value apportionable to premiums are still non-taxed, so MEC’s can still be very useful in estate planning.
A 1035 Life Insurance Exchange refers to a transaction in which you trade an existing life insurance policy or annuity for a new policy or annuity. The exchanges are authorized by I.R.C. §1035 (hence, the name).
The advantage of a 1035 Exchange is that it allows you to swap your existing policy for something better suited to your present situation without incurring any current tax liability.
And, the new policy or annuity inherits the basis of the former policy.
1035 Exchange Example
For example, if you have a whole life policy with a $25,000 cash value and a $20,000 basis, you can apply the $25,000 toward a new annuity, which then has a $20,000 basis.
Instead of owing income taxes on the $5,000 in growth right away, you can spread the taxes out over the life of the annuity.
Meanwhile, the money that would have gone to the IRS continues growing tax-deferred in the new annuity, until it is eventually paid out. And, of course, the inherited basis remains tax-free when it is distributed.
Along with the favorable tax treatment, there are numerous other structural advantages of cash-value life insurance that make it a valuable component in a financial portfolio.
With guaranteed growth, a standard whole-life policy has essentially zero risk of loss.
Variable policies can see some reduced value in the event of poor investment performance, but the risk is almost always contractually limited.
And many of the popular new indexed policies allow policyholders to share in strong stock market performance while guarantying that the policy will never lose value.
State Guarantee Agencies
Even in the exceedingly rare event of an insurance company bankruptcy or insolvency, well-funded state guaranty associations guaranty life insurance policies at least up to the amount of premium paid.
Permanent policies also enable you to tailor your strategy for leveraging a policy according to your individual financial objectives and preferences. With the same whole life policy, you could
- maximize the eventual pay-out to your beneficiaries by investing dividends back into the policy, paying full or even extra premiums, and avoiding loans or withdrawals; or
- surrender the policy for its full cash value to fund retirement; or
- take partial withdrawals to pay for vacations, large purchases, and/or emergencies but reserve enough policy value to cover funeral costs, administration expenses, and any estate debts; or
- exercise the reduced paid-up option to retain a guaranteed non-forfeitable reduced death benefit with no further obligation to pay premiums for the rest of your life; or
- convert cash value into an annuity with a 1035 exchange and receive guaranteed payments for the rest of your life.
As an added bonus, a cash-value policy can serve as collateral to secure favorable credit rates as long as the policy remains intact.
In terms of asset protection, cash value life insurance creditor protection provides that the cash value is better shielded from creditor claims than most other financial assets.
In almost every state, at least a portion of a policy’s cash value cannot be attached by creditors or by a bankruptcy trustee.
In many states, including Florida, Georgia, New York, Texas, Pennsylvania, and Ohio, the cash-value life insurance exemption is unlimited. In those states, the amount of cash value built up is irrelevant – neither a creditor nor a trustee in bankruptcy can attach the policy.
Further, most states also protect death benefits from attachment by the insured and/or the beneficiary’s creditors.
Cash-value life insurance offers a reliable means of providing for your loved ones in the event of disaster. But it also includes favorable tax treatment and structural advantages that make it a great resource for retirement and estate planning.