Are There Consequences?
Life insurance is designed to provide financial security to your loved ones in the event you pass away. There are a variety of life insurance companies, types of policies and riders that can be added to them. But, whole life, a form of permanent life insurance, offers ways to benefit you and your heirs, as well as savings on taxes to those who get good advice on how they work.
Permanent (or whole) life insurance is often criticized for costing more than term life policies that often expire before the person being covered. Permanent life policies, provided premiums are paid, ensure protection for heirs upon your inevitable death. They enable heirs to pay outstanding debts, funeral costs and countless other things.
But the tax benefits, for you and your beneficiaries, are important to understand.
Here are some key details you need to know about their tax-advantaged features:
-Permanent life insurance policies have tax-deferred growth. Whether whole life or universal life or a different type, permanent life insurance policies build cash value that continues to grow over time. Depending on the type of policy, you can tie them to index funds or other investments, and the gains compound “tax deferred,” much like retirement savings accounts.
-Many permanent life insurance policies also receive tax-free dividends. Some insurance companies, such as mutuals owned by policyholders, may share some profits with policyholders annually in the form of dividends.
The dividends on eligible policies generally do not have to be reported on policyholders’ tax returns because they are considered to be a return of some policy premiums. They are only taxable if they exceed the amount of premium paid into the policy.
-Once your insurance plan has accumulated enough cash value, you can take cash back. Another life insurance benefit is the ability to access and use the cash value you amassed so far for a child’s college tuition, supplemental retirement cash, unexpected medical expenses, a property down payment or any other reason.
Some people even use the cash value to purchase more insurance to leave loved ones a higher death benefit. There are three ways to easily access the money:
- You can borrow against your cash value. This loan, essentially borrowing from yourself, does not require bank approval. The loan will have fees and interest charges added by the insurance company until you pay it back. You can opt to not pay the loaned money back. However, any amounts still due will be reduced from the death benefit.
- You can request a withdrawal aka a distribution. Much like accessing money in an IRA, people use their cash value as retirement assets later in life, when they are no longer bringing home a regular paycheck. With distributions and withdrawals, any funds withdrawn that are investment earnings may be taxed as income. Again, the amount is also deducted from proceeds available in the event of your death.
- Lastly, you can cancel the policy completely and take out any cash value you have stockpiled, which is subject to income taxes. If this happens in the first five to 10 years, depending on the policy terms, however, there may be a surrender fee charged. The actual amount depends on the policy terms and how long you had the policy.
-Whole life insurance offers tax-free death benefits. Leaving money to your spouse, children or other beneficiary is the main point for buying life insurance. However, you might not be aware that the people who receive the death benefit from your policy usually do not have to pay federal or state income taxes on the proceeds.
So, if you have a life insurance policy with a $500,000 death benefit, your beneficiary will receive $500,000 (unless there are loans or other complications involved). The money is untaxed and usually settled far quicker than other estate assets, like property.
Some people purchase life insurance benefits to ensure there is cash on hand to pay inheritance taxes that will be assessed on other assets in their estate.
Exceptions And Seeking Advice
There are certain circumstances in which life insurance benefits may be taxable. Generally, they only apply to individuals with very large estates. To avoid the issue and keep the proceeds from the insurance becoming part of an estate, people sometimes transfer the policy to an irrevocable trust.
However, if the policy is transferred within the 36 months before your death, it is still subject to estate taxes.
Life insurance is complex. Deciding between policies and weighing options that affect the protection you want or loved ones requires talking to a financial advisor with expertise. Factum Financial, for example, specializes in advising clients on the use of life insurance products to protect heirs while building wealth.
Rather than focus merely on selling someone a policy, they work with clients afterward to ensure they maximize their results and use of the policy.
For more financial insight, follow this link to check out the previous blog.