While the primary role of life insurance is to offer financial assistance to your loved ones after you’ve gone, it may also offer the potential for “tax-free” retirement income. In fact, certain types of life insurance offer you the opportunity to build up cash value within the policy that you can access through policy loans and withdrawals—and take advantage of tax benefits in the process.
Here are five tax benefits life insurance can offer, and why you may want to consider purchasing a life insurance policy as a part of your retirement strategy.
1. Tax-Free Assets
When considering retirement, many people think of IRAs and 401(k)s. Contributions to these retirement plans are made with pre-tax dollars, saving you taxable income in the years contributions were made. However, they do come with some drawbacks when it comes to taxes: in traditional IRAs and 401(k)s, once you’re eligible to withdraw your savings at age 59 ½, you must pay income taxes on the full amount you’ve saved as you receive payment, and you may be concerned about how tax rates could change in the future and what you might eventually owe in taxes.
Life insurance works differently. Premiums paid into a life insurance policy are made with post-tax dollars. While that doesn’t help reduce your taxable income up front, you won’t owe taxes on the amount of money you’ve paid into your life insurance policy or on the death benefit that gets paid out. By paying taxes now at historically low rates, unknown future tax rates won’t affect the amount of money paid to you or your loved ones.
2. Tax-Deferred Growth
Some life insurance policies, called permanent life insurance, can earn interest on the premium you’ve paid. The premium is your cost to purchase the life insurance contract. A portion of that premium goes toward the cost of insurance and the remaining premium plus interest is called your cash value. This adds a savings element to your policy.
Better yet, that cash value grows tax-deferred. When you withdraw money, the amount you’ve paid in premiums can be withdrawn tax-free, while any interest earned will not be taxable (assuming the policy is not deemed a MEC, or a Modified Endowment Contract).
3. Life-Insurance-Backed Loans
Say you need a loan for a new car, some home renovations, or college tuition for a grandchild. You can use the cash value in your life insurance for an income-tax-free loan—borrowing against your life insurance without worrying about taxes.
Policy loans and withdrawals will reduce available cash values and death benefits, and may cause the policy to lapse or affect any guarantees against lapse. Loans, withdrawals, or partial surrenders from a MEC policy are subject to income tax to the extent of any gains in the policy, and if the payment occurs prior to age 59 ½, a 10 percent federal additional tax may apply.
Essentially, your cash value provides collateral for the loan. Insurance companies have varying guidelines outlining how much cash value a policy must have before you can borrow against it— and what percentage of cash value you can borrow.
Depending on your policy, you may owe interest when you pay back the loan. When you pay back the loan and interest, you’re restoring your cash value—essentially, you’re paying yourself back. If you’re unable to pay back the loan, the amount remaining plus any interest owed will be deducted from your death benefit.
Most permanent life insurance policies allow for loans or withdrawals of any available cash values on a tax-free basis.
4. Protection In Case of the Unexpected
Unforeseen events happen, like medical expenses or home repairs. If something like that happens to you, you may need to access your cash values. Most likely, you’ll want to pay as little in taxes and fees as possible to cover those unforeseen costs.
Most permanent life insurance policies allow for loans or withdrawals of any available cash values on a tax-free basis. But be aware, you cannot withdraw so much that you will lose your policy. You need to carefully manage your policy's cash values to ensure your policy remains in force. Excessive withdrawals or poor policy performance could cause your policy to lapse. Your financial professional or the insurance company who issued it can help you determine the appropriate amount to withdraw and still maintain your coverage.
Unlike an IRA or 401(k), you can take a loan or withdrawal from your cash value life insurance policy before age 59 ½ without paying a 10 percent federal penalty or income taxes on the amount withdrawn, assuming the policy isn’t a MEC.
5. Seamless, Tax-Free Policy Exchange
If your needs change significantly after you first purchase a life insurance policy, or there are newer policies available that offer benefits or riders not previously available, then it may make sense to exchange your policy for another. Most life insurance policies offer the flexibility to do that—without worrying about taxes.
What's more, if at some point you no longer have a need for the original death benefit but want income in retirement, you have the option to convert your policy's cash value to an annuity. This makes it easier to receive guaranteed income for the rest of your life (depending on the type of annuity). Since life insurance is paid in a lump sum after you die, some people choose to move their money to an annuity to provide guaranteed retirement income only annuities provide.
By using a 1035 exchange, the transfer is completely tax-free. The life insurance death benefit is eliminated, but, instead, you receive steady income from the annuity without paying income taxes on your principal, because these funds have already been taxed. If you don’t have any beneficiaries and don’t want to leave money behind, exchanging your life insurance for an annuity is one way to use these funds to your advantage while you're alive.
If you’re considering a policy exchange, make sure you evaluate your current and future needs, and any consequences there may be to your overall retirement strategy as a result—such as a surrender charge on the old policy, new surrender charge period on the new policy, and other considerations and differences between the old and the proposed new policy.
When it comes to planning for your protection and retirement income needs, life insurance may be a good option for you. But, as with all financial strategies, it depends on your specific needs. A financial professional can help you develop a strategy that works for you and your retirement goals.
Policy loans and withdrawals will reduce available cash values and death benefits, and may cause the policy to lapse or affect any guarantees against lapse. Additional premium payments may be required to keep the policy in force. In the event of a lapse, outstanding policy loans in excess of unrecovered cost basis will be subject to ordinary income tax. Tax laws are subject to change. You should consult a tax professional.
The purchase of a life insurance policy is an important decision. Be sure to carefully evaluate the features and benefits, costs and limitations of any policy you are considering before making a purchasing decision.
Life insurance may require you to qualify for it medically and potentially financially through underwriting. Policy and feature availability may vary by state.
All guarantees are backed by the financial strength and claims-paying ability of the issuing company.