Many people think about life insurance as strictly a death benefit. A few more savvy individuals know that this death benefit is NOT taxable to the beneficiaries. However, only the truly astute understand the tax advantages that permanent life insurance offers (as opposed to term life) not only to beneficiaries but to policy owners, providing a life benefit. After all, it is called “life” insurance for a reason.
As a teaser, the tax advantages of permanent life insurance may be used to expedite cash value accumulation for many purposes including retirement planning and investing. Infinite banking strategies rely on the tax advantages of permanent life insurance . This article will walk through the various tax advantages of permanent life insurance and, in the process, may even convince you to look at permanent life insurance as part of your financial plan for wealth building into the future and also today.
Death Benefit [Tax Exempt Income for Beneficiaries]
This most obvious tax benefit of life insurance is the fact that the death benefit is NOT income taxable to the beneficiary. This is the only tax benefit that is offered by ALL TYPES of life insurance INCLUDING term life and the various types of permanent life insurance. The amount received by your beneficiary, whether in a lump sum or other payout, does not constitute taxable income.
26 U.S. Code Sec. 101, subsections (a) and (g), of the I.R.S. Tax Code provides that “proceeds from a life insurance policy payable by reason of death” are generally NOT included in the GROSS INCOME of the payee. EVEN in circumstances where “accelerated benefits” are paid to the policy holder, perhaps because they are terminally ill, this code section applies so that taxable income is not recognized.
Income Tax Advantages of Permanent Life Insurance
The following income tax advantages apply to all permanent life insurance contracts that accrue cash value. To accrue cash value, a policy must be a permanent (or cash value) life insurance policy as differentiated to a term (or temporary) life insurance policy. For a permanent life insurance policy to qualify for tax advantages under the I.R.S. Code, the policy must be a life insurance contract NOT be a modified endowment contract (“MEC”).
26 U.S. Code Sec 7702 contains the rules that define an “insurance contract” as opposed to a MEC.
So, if a policy qualifies as an insurance contract, the pre-ordained tax advantages sanctioned by the I.R.S. code apply which include the following common benefits:
- Tax deferred growth
- Tax free dividends
- Cash withdrawals
- Policy loans
Is Life Insurance Tax Deductible?
Often insurance professionals respond to the question whether life insurance premiums are deductible with a resounding “no” and “sorry”. However, the more complete answer to this question is that premiums may only be deducted as expenses in certain limited circumstances involving business expenses.
The key is if a business owner pays premiums on behalf of a key employee as part of an executive bonus plan, deferred compensation plan or split dollar plan, the premiums may be deductible if they are recognized as income to the employee.
The question of whether premiums are recognized as income for any of the above strategies is very fact specific, involving questions such as when the employee has access to the cash value in a insurance policy.
Permanent Life Insurance and Tax Deferred Growth
A major advantage of permanent life insurance is that cash value increase (or “gain”) is not realized (for tax purposes) until it is withdrawn from the policy. This is true as long as the policy qualifies as an insurance contract EVEN IF strategies are used to maximize the policy cash value through paid up policy additions.
This an important advantage when considering permanent life insurance strategies such as the infinite banking concept®, which is based upon a number of concepts such as the velocity of money and creating financial arbitrage to facilitate other activities such as real estate investing through cash value life insurance.
Tip: If the cash value in the policy is not used prior to death, it will be forfeited to the insurance company AND only the death benefit will be paid out to the beneficiaries. So, it is important to consider the withdrawal of cash value as part of your financial and estate planning strategy.
There are various types of permanent life insurance that all offer tax deferred cash value accumulation, which are indexed universal life insurance, variable life insurance, private placement life insurance, and participating whole life insurance. And in some cases guaranteed universal life insurance offers some cash accumulation.
Permanent Life Insurance and Tax Free Dividends
For certain types of permanent life insurance policies, namely policies that pay dividends, the additional tax benefit of “tax free dividends” is available. This is because the I.R.S. considers dividends to be a “return of premiums paid” rather than income. This advantage is typically realized in policies issued by mutual whole life insurance companies. Dividends paid that exceed the amount of premiums paid into the policy may likely be considered income by the I.R.S. when withdrawn from the policy.
Permanent Life Insurance and Policy Loans
The cash value in an insurance policy, may be used to secure a loan from the insurance company up to the amount of the cash value in most cases. This is another huge aspect of the infinite banking concept® because you can access life insurance policy cash for retirement or other investments and policy cash value keeps accruing.
I equate this with the life insurance policy accruing equity in a way similar to real estate. I talked about this comparison comparing 1035 and 1031 exchanges. With a non-direct recognition life insurance company, the payment of dividends is NOT reduced or negatively impacted by outstanding policy loans.
Of course, because the cash received in this circumstance is a loan, it is NOT recognized as income by the IRS.
Permanent Life Insurance and Policy Cash Withdrawals
Even if cash is withdrawn from the policy cash value (verses taking it as a policy loan), this cash withdrawal is NOT considered income, or gain, until the amount exceeds the amount of premiums that have been paid into the policy. However, it is important to know that if a policy is “surrendered” meaning that it is cashed out and terminated, surrender charges may apply even if no taxable income is recognized.
Estate Tax Advantages of Permanent Life Insurance
Life insurance is often used to provide liquidity to pay federal estate taxes. Term or permanent life may both be used for this purpose because the focus is the death benefit payable to the heirs. However, for long term estate tax planning for liquidity, a guaranteed universal life policy should be considered as minimum protection due to the rising cost of term insurance over a lifetime.
Liquidity and Business Continuity Succession Planning
The issue of liquidity is especially critical for “asset heavy” businesses such as car dealerships, sports teams, or trucking companies. What often occurs is that the cash simply isn’t available to pay the estate taxes AND assets must therefore be sold or heavily leveraged.
Be aware that this issue can be compounded by the fact that lenders may be highly apprehensive to loan cash during a time as unstable as following the death of a principal business owner. This is a key consideration when undergoing family business succession planning as part of a business continuity succession plan.
Exceeding the Estate Tax Exemption
The key to estate planning is remembering that estate taxes will be due if you exceed the federal estate tax exemption.
Any amount in excess of the exemption amount will be taxed at an approximate 40% rate, and this amount is typically due within 9 month of the estate owner’s date of death.
The taxable estate is determined based upon the gross value of the estate which includes all the estate assets as well as insurance death benefit payments.
Tip: State inheritance taxes may also be due, independent of the federal estate tax burden. Thus it is important to understand the laws of your state of residence OR state of incorporation in order to avoid unpleasant estate tax surprises.
Using an ILIT for Estate Tax Planning
The strategy behind using an irrevocable life insurance trust (“ILIT”) for estate planning is moving assets out of the taxable estate.
This is because only assets that are owned by the deceased estate owner are deemed part of the estate tax calculation at time of death. Assets that were transferred outside of the estate simply “don’t count”.
So, when you transfer assets to an ILIT, either in a lump sum or over a period of years, those assets are moving from your estate into the trust that will then pass to your designated beneficiaries.
Transfers to ILITs are often done through gifting assets as part of a strategy to decrease an estate while providing a reserve for future generations.
Tip: The I.R.S. imposes a 3 year rule which requires that assets must be in the ILIT for a minimum of 3 years prior to the estate owner’s date of death in order to be excluded from the taxable estate.
Now you have a concise summary of the various tax advantages of life insurance, both for income tax AND estate tax planning.
If you have any questions concerning your life insurance or estate planning connect with us today.