Whole Life Insurance as a Tax Diversification Strategy

George Reilly |

For many people, life insurance forms the security foundation of their financial plan. While most financial planners recommend that life insurance be purchased for its protection, and not as a primary savings vehicle, few would argue that cash value life insurance doesn’t have some fairly unique and attractive savings features. When these are considered in the context of a person’s overall savings and investment strategy, they may offer some advantages especially for providing additional tax diversification of income sources.

Savings Features of Cash Accumulation Life Insurance

Competitive rates of return: Cash value life insurance comes in several forms. Some, such as universal life policies, offer competitive interest rates comparable to those available from certificates of deposits. For those who are willing to assume some risk for the chance of a better return, there are variable-universal life policies that can earn returns based on the performance of investment accounts. Many of these provide minimum rate guarantees (for an additional charge) so your cash value has limited downside exposure to the market.

Tax-free accumulation: As long as a sufficient corridor exists between the amount of cash value accumulated inside the policy and the amount of the death benefit, the Internal Revenue Code treats the earnings in life insurance policies very favorably by not taxing them currently.

Tax-free access: Monies withdrawn from life insurance cash values are not taxed to the extent that they are original principal. When withdrawing money from cash value, the policy distributes principal first, so you won’t be taxed until you begin withdrawing the earnings. Also, policy loans are not taxable, but if the policy lapses the loans will be includable as income to the policyholder. It should be noted that withdrawals and loans will reduce the death benefit payable and could also adversely impact the cash value which could result in a policy lapse.

No distribution requirements: Unlike qualified plans, there are no penalties for withdrawals taken from life insurance policies before 59 ½. Also, there are no minimum distribution requirements such as with IRAs.

No maximum contributions: Some policies allow for adjustable premiums which mean you can increase your premium payment so more of it is apportioned to the cash value account. The only limitation to be concerned with is the relationship between the cash value and the death benefit.; If the cash value exceeds a certain percent of the death benefit, it could change the tax status of your life insurance policy as a modified endowment.

Not includable in Social Security tax: Generally, income from life insurance policies, taken as withdrawals or as loans is not included in the income calculation for taxes on Social Security benefits.

Life Insurance Income Strategy for Boomers

While it is not recommended that a person over the age of 55 purchase a life insurance policy for purposes of saving for retirement, those Boomers who already own cash value policies should look to them as a part of their overall retirement income strategy. By accessing the cash values of their life insurance policies first, they can possibly delay the need to begin taking Social Security payments. They can also allow their qualified plans savings to continue to grow tax deferred, although most plans require that income distributions begin by age 70 ½.

Retirement Income Planning for Gen X, Y and the Rest

These days retirement planning should be done in the context of a person’s overall financial plan with consideration for additional ways to provide retirement income. Life insurance is a core financial planning vehicle for anyone who has loved ones who are dependent on them for financial security. Purchased early enough, at least 15 to 20 years before retirement, life insurance cash values can overcome the early expenses of the policy and, without the encumbrance of taxes, grow into a sizable asset by retirement age.

Some planners will advocate purchasing term insurance and then investing the difference which may be a sound strategy for some people. The problem for most people is that their need for life insurance might go on past the expiration of the term policy, and, generally, younger people are not very disciplined when it comes to saving. Additionally, other savings vehicles, such as savings accounts and money market funds, don’t enjoy the same tax advantages as life insurance.

Most planners would agree that a person’s qualified retirement plan should take funding precedence over other retirement savings vehicles that don’t offer tax advantages. They would also agree that life insurance is a vital part of the overall financial plan, for anyone who is responsible for the financial security of others. By allocating excess funds towards a cash accumulation life insurance policy to provide permanent protection, the premiums that are paid into a cash value policy will be able to pull double-duty to create a supplemental source of tax-favored retirement income.