The Tax Advantages of Life Insurance

Life insurance is the most flexible financial tool known to humankind!  Policyholders own life insurance for various reasons.  Some range from replacement of income to covering a mortgage to two partners insuring their business to paying off estate taxes.

Often, the most important reason to own life insurance is the tax-free transfer of a large sum of money to beneficiaries at the death of the insured. It is a valuable benefit to families and estates and the protection of loved ones and those depending on you.

The protection of widows and orphans that life insurance provides is so vital in fact, that Congress has granted life insurance with numerous important tax advantages.

While premiums for life insurance are generally not tax-deductible, nearly everything else about permanent life insurance policies, including universal life, variable universal life and whole life insurance enjoy significant favorable tax treatment compared with other financial alternatives.

1. Tax-free death benefits — As mentioned, death benefits paid to beneficiaries are generally totally free of federal income tax.
2. Growth within the policy is tax-free — As long as your policy has cash value, all growth within that cash value account or variable universal life subaccounts is tax-free. Any commensurate growth in eventual death benefit is also tax-free.
3. Loans against your policy are tax-free— As your cash value grows, you may wish to access some of the cash for other purposes. There are no age restrictions on this benefit. You can borrow against the policy for any purpose and free of federal income tax.

This money can be used to pay college expenses, finance cars, down payment on a home, secure a loan, pay retirement living expenses or anything else. You may choose to pay your own policy back or allow the life insurance company to deduct the balance owed from any eventual death benefit. The choice is yours!

If you are receiving Social Security benefits, loans from your policy are not counted against you for the purposes of calculating taxes on Social Security benefits.

• Tax-Free Exchanges — Under Internal Revenue Code Section 1035, you can exchange your universal life insurance policy for an annuity free of income tax. This is tremendously useful for anyone who may no longer need or want a life insurance policy, so you retain the tax-advantaged cash without having to pay further premiums.
• Estate tax benefits — Personally owned life insurance contracts are considered part of your taxable estate. However, if you are concerned that your estate may be subject to an estate tax, you can transfer your insurance policy to someone else or transfer it into a trust, which removes it from your taxable estate. 
• Bypasses Probate: All life insurance policies have a beneficiary so they bypass probate and are private, meaning nobody can look up how much you had, nor will your heirs pay court costs of proceeds, which are paid directly to beneficiaries bypassing Uncle Sam.
• Protected Cash Values from the FAFSA: It is important to know, for college planning, that cash-value life insurance is not included in FAFSA (Free Application for Federal Student Aid) calculations, meaning it is FAFSA-friendly!  For example, a parent wants to lower their EFC (Expected Family Contribution) score, so they reposition a $100,000 CD (bank certificate of deposit) into cash value life insurance.  Because CDs are included on the FAFSA and cash-value life insurance is not, this move lowers their EFC score by almost $6,000, which puts the family in a position to qualify for an additional $24,000 ($6,000/year X 4 years) of merit-based endowment (FREE) money!

My takeaway

Given the many tax advantages of permanent life insurance, it should be part of a well-balanced portfolio and it’s the most efficient way to pass down assets to the next generation.  Life insurance does have moving parts and can be confusing to understand if not explained properly.  Recently, there have been major changes to underwriting and we have two insurance companies that will consider a non-smoker rating for those who smoke marijuana (or take pot gummies, tinctures, etc) or cigars or pipes if they don’t smoke cigarettes.  Smoker’s rates run about double non-smokers rates so if you or a family member falls into this category, feel free to reach out to me for a review at [email protected].