Whether you're in your 20s, 30s, 40s, 50s, or 60s (we're looking really hard at you, Millennials), life insurance serves a dual purpose for Americans: It provides a financial cushion for your loved ones after you’re gone and it helps you confidently prepare for long-term financial goals and expenses, like paying off student loan debt, paying off a credit card, or saving for an emergency fund. No matter what age group you belong to, life insurance is something you should consider purchasing, either now or in the future. The only equivalent to life insurance is long-term investing and saving that takes into account your current lifestyle and future goals.
When you first purchase life insurance, it’s easy to think of it purely in terms of premiums and payouts, especially if your primary funding comes from your annual salary and monthly paychecks. But why stop there? Life insurance has much more to offer.
Let’s look at a few ways life insurance can save you money and provide other advantages when tax time rolls around.
A quick point of clarification: Unless otherwise explained, the taxes we’re talking about here are federal taxes. State tax codes may have specific advantages or disadvantages for life insurance holders, but those can vary widely and need to be looked at by state.
Let’s start by talking about the elephant in the room: death. We already explained how life insurance can help your loved ones if you pass away–and unfortunately, everybody does eventually. When you die, your assets, including the death benefit in your life insurance policy, will be inherited by your loved ones.
Legally speaking, your loved ones will have to report most of the money you leave to them to the IRS as taxable inheritance income. This includes property, IRAs, and retirement plans. The resulting tax bill can be pretty hefty--your loved ones might end up paying as much as 35 cents per dollar on their inheritance. If you leave debt behind, your loved ones might have to pay that back out of their inheritance as well.
Having an inheritance account balance wiped out by debt or a high tax bill is the worst-case financial scenario for your beneficiaries. You can avoid a lot of these problems and give them less to worry about by having a life insurance policy and average retirement savings (this is why it's so important to set retirement savings goals early on in your career).
If someone receives a death benefit payout from a life insurance policy, it does not have to be reported as income on their federal tax return. Similar to a Roth IRA, this essentially makes that money tax-free, except for in a few special cases. It’s basically a large gift of tax-free cash from you to your beneficiary, ensuring they won’t have a surprise call from the IRS after you’re gone.
One of those special cases is if you name your estate as the beneficiary of your life insurance policy instead of a specific person. While there are some valid reasons to do this, adding your policy to your estate makes the death benefit payout subject to the probate process. Probate is the process of going through a deceased person’s will and assets and making sure that all debts and taxes are paid, then paying out the correct amounts to all of the inheritors for the estate.
For life insurance purposes, this is another situation that means that taxes may have to be paid with the money you leave behind. To avoid this, make sure to regularly update your policy to be sure the beneficiary is a living person, not your estate or someone who has passed away. Death benefits paid out to an individual don’t have to go through probate, (although the value of the benefit might be added to the total value of the estate in some specific cases).
The tax advantages of having a life insurance policy don’t only help your beneficiary–they can also help you. Some financial investments are taxable, so they can cost you money over the long term. Life insurance, however, has a few unique properties that you need to know about. There are advantages to owning a life insurance policy that can help you to help yourself during your life by growing your wealth and increasing your financial security. A life insurance policy is another way to ensure your earnings go exactly where they're supposed to –
Let’s start with one of the biggest advantages–cash value. The cash value of a permanent life insurance policy–what we call Whole Life or Indexed Universal Life–is not taxed. You’ve probably noticed that these types of policy have a fixed-rate premium, meaning that the amount of your premium payments will be the same for as long as you have the policy. The reason for this is that part of each payment goes towards the cost of insurance and the rest goes into building up the cash value of the policy.
The cash value of your life insurance policy is considered a “tax-deferred” asset. That means that you only have to pay tax on it if you make a withdrawal. It’s also considered a living benefit–meaning it’s the part of your policy that you can use while you are still alive, similar to a savings account. For this reason, the amount of cash value that a life insurance policy has is often much lower than the total death benefit.
But how can this help with your taxes? Basically, if you borrow money from the cash value of your own life insurance policy you won’t need to pay taxes on it as long as you borrow an amount lower than the total value of premiums you’ve paid into the policy. In other words you can borrow less than what you’ve paid without worrying about it being taxed.
In fact, as long as the policy is active, you don’t have to repay the loan or pay taxes on it. (This will reduce the amount of death benefit your beneficiaries will receive, though.) Keep this in mind if you need extra cash for investment or emergencies and don’t want a big tax bite taken out of it.
You aren’t taxed on your life insurance policy’s growth in value over time, either. The cash value of a Whole Life policy usually earns a relatively small amount of simple interest over time. That interest isn’t taxed.
The cash value of an Indexed Universal policy can earn far more, because it’s connected to a stock index instead of earning simple interest. This means it can earn a return if the stock market is doing well. Again, the returns earned on the cash value of your life insurance in this way aren’t taxed. This means that as the value of your life insurance grows, you won’t be paying tax on that growth the way that you would on an independent stock portfolio or retirement account.
This can save a lot of money in the long run–both in taxes paid, and the returns you get on the money you aren’t paying out in tax, which stays in your policy’s cash value and continues to accrue interest or market returns.
Speaking of growth, as your net worth increases, life insurance can be a good way to protect your wealth from high tax rates. This can help you create a more stable financial cushion for yourself and your loved ones as you get older. It can also help you maintain a steady nest egg despite fluctuations in markets and government policies.
If you max out your contributions to your 401(k) or other retirement accounts, you can contribute additional cash to your life insurance policy with no penalty. There is no yearly limit on how much extra money you can contribute to your life insurance policy, so this can be a good way to shelter your extra savings from taxation. Simply add that money to your life insurance, and watch the cash value increase.
While there are a lot of distinct tax advantages that come from owning a life insurance policy, there are a few things to keep in mind when you’re planning for tax season. Not every transaction in your life insurance policy is tax-free or tax-advantaged, and you don’t want to be surprised by unexpected charges.
While death benefits and loans on the cash value of your life insurance policy are tax-advantaged, premium payments aren’t tax-exempt. The only exception is when you are paying the premiums on someone else’s life insurance policy as a gift.
If your beneficiary receives the death benefit from your policy in installments for any reason, the balance is usually held in an account that the installments are paid out of over time. If that account earns interest (and it usually does), the interest is taxable. Depending on the amount of the death benefit, this may undo the advantage of passing your money down in a death benefit, so make sure that your beneficiary knows about this potential cost.
If you sell your life insurance policy instead of taking a loan on the cash value, the money from the sale counts as income and will be taxed. It can be tempting to do this because you can often get a good deal on the sale–however, you might lose the extra cash you make in taxes. It’s a good idea to consider the numbers from a policy sale very carefully, and if you must sell your policy, consider a trade, not an outright sale.
Many of the tax advantages of life insurance as a living benefit explained here only apply to Whole or Indexed Universal policies. For example, term life insurance provides the advantage of a tax-free death benefit payout to beneficiaries but does not give the policyholder the ability to take a tax-free loan out on the cash value. If you want to have these advantages as well, you might want to look into the differences between term and whole life insurance policies and make the switch. Financial advisors who specialize in life insurance can present you with various options.