How to maximize the tax benefits of life insurance

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Life insurance can be a strategic tool to protect against taxes by providing a tax-free death benefit to beneficiaries, helping to cover estate taxes, and allowing for the transfer of wealth outside the taxable estate when structured properly within a trust. 

To explore the tax benefits of life insurance, we spoke to Barry Flagg, president and founder of Veralytic, an independent life insurance research company

What follows is a lightly edited version of our conversation. 

Insure.com: What are the primary tax benefits associated with life insurance policies, specifically cash value life insurance policies that offer a savings-like component in addition to the death benefit?

Flagg: Cash value life insurance policies enjoy four tax preferences not found in any other financial product: no tax on the growth of the policy account, no tax on withdrawals of premiums paid from the policy account, no tax on otherwise taxable gains when taken as loans from the policy account, and tax-free death benefits that can be used to repay policy loans and provide for beneficiaries.  

Insure.com: How does that differ from other investment products? 

Flagg: Different types of investment vehicles are subject to different tax rules.  Let’s look at traditional stock brokerage accounts, mutual funds, annuities and life insurance.

Traditional stock brokerage accounts—like those offered by JP Morgan, Merrill Lynch and Charles Schwab—and mutual funds are subject to taxes on three components of those accounts. The first is the account’s growth, such as interest income and short-term capital gains, which are the increases in value of an asset you’ve owned for less than a year. The second is on distributions from the account, such as long-term capital gains, which are increases in the value of an asset you’ve owned for more than a year. The third is at death, which includes income for a decedent (IRD) – the untaxed income on anything the deceased earned – and estate taxes. Currently, estate taxes apply only to estates exceeding $13,610,000 for individuals or $27,220,000 for married couples, known as the lifetime exemption amount.

On the other hand, increases in the value of an annuity account is not taxed while the annuity owner is alive. However, distributions are taxed at ordinary income rates, subject to an exclusion ratio – a percentage that’s not taxed –  if the account is irrevocably annuitized over a specified period. Taxes, however, are imposed at death, including IRD and estate taxes. However, as mentioned earlier, estate taxes currently apply only to estates exceeding the lifetime exemption amount.

Finally, the rules governing life insurance policy accounts are the most favorable because they do not tax the account’s growth or distributions, provided distributions are taken as withdrawals of premiums paid or loans against otherwise taxable gains. Additionally, taxes are not imposed at death since death benefits are tax-free and can be exempted from estate taxes by placing the policy in an irrevocable life insurance trust (ILIT) or a more modern actively managed life insurance trust (AMLIT).

Insure.com: Let’s talk about permanent life, which are policies with a cash value and that are in effect as long as you’re alive provided you pay premiums needed to cover cost of insurance and policy expenses. How does the cash value accumulation in permanent life insurance policies receive favorable tax treatment?

Flagg: The cash value accumulation in permanent life insurance policies benefits from favorable tax treatment under IRS Tax Code Section 7702, which establishes guidelines for the tax status of whole life, universal life, and other types of permanent life insurance. This part of the tax code ensures that the primary purpose of life insurance is to provide a death benefit rather than an investment vehicle. These rules apply only to cash value life insurance policies, not term life insurance policies.

To qualify for favorable tax treatment under Section 7702, a life insurance policy must meet the IRS’s definition of life insurance (DOLI) and pass either the cash value accumulation test (CVAT) or the guideline premium and corridor tests (GPT), which determine whether the premiums paid are reasonable to the primary purpose of providing a death benefit.

If the policyholder overfunds the policy or withdraws or borrows excessively from the cash value, the policy benefits may become subject to taxes and penalties. While the insurer is responsible for complying with DOLI rules, policyholders manage the policy to preserve desired tax benefits. In addition, policyholders are responsible for understanding whether desired tax benefits are worth the cost of the life insurance.

Insure.com: Can policyholders access the cash value of their life insurance without triggering a taxable event?

Flagg: Yes, by withdrawing previously paid premium contributions or taking out policy loans, which are not taxable because they are considered borrowed funds rather than a redemption of investment gains or income. In other words, the tax rules for life insurance permit what would otherwise be taxable gains to be accessed tax-free as loans. 

However, tax-free loans only remain tax-free while the policy remains active. If a policy with a loan ever lapses, then previously tax-free distributions are “recaptured” and become taxable — typically at the highest possible ordinary income tax rate.  

Some policies include a feature called an over-loan protection (OLP) rider that prevents excessive borrowing from triggering a policy lapse. However, OLP riders have not been tested in tax court, so it’s unclear how the IRS might treat or tax policies with an OLP rider. 

Either way, policyholders should also note that withdrawals and outstanding loans will also reduce the death benefit payable to beneficiaries.

Policyholders can also transfer the cash value of their life insurance from one insurer to another without triggering a taxable event. These tax-exempt exchanges are permitted under IRS Tax Code Section 1035, allowing policyholders to move their policy to a higher-rated insurer if their current insurer has been downgraded in financial strength or claims-paying ability. They can also switch to a provider with lower cost of insurance charges if costs in their existing policy are higher than those currently available or transfer their policy to an insurer with a track record for superior performance if their current policy is underperforming.

Lastly, some policies offer riders or living benefits that allow policyholders to access a portion of the death benefit early for terminal illness or long-term care needs. However, tax implications can vary depending on individual circumstances and policy details, so it’s important to consult a tax professional before withdrawing, taking loans, or exercising a rider for any other benefit from your life insurance policy or considering the sale of your life insurance policy. 

Even when accessing the cash value may not result in immediate taxes, it’s crucial to consider the long-term effects on the policy and the benefits available to your beneficiaries.Contact your financial advisor for a Veralytic report, or click here to be connected with a Veralytical Advisor near you. 

Barry Flagg

Expert Advisor

 

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Barry D. Flagg is the inventor and founder of Veralytic®, the leading online publisher of life insurance pricing and performance research and product competitiveness ratings. Veralytic is the result of his unique background in both the fiduciary investment business where he became the now oldest, youngest Certified Financial Planner (CFP®) in history, and as a life insurance expert consistently recognized in the top 1% of the industry. He’s renowned for applying Prudent Investor Principles to life insurance product selection or retention and portfolio management. As a result, he serves as sub-advisor to thousands of irrevocable life insurance trusts (ILITs) as well as RIAs and wealth managers, is a regular contributor to Forbes for articles about life insurance, leads curriculum development and instruction for Applied Fiduciary Practices involving life insurance for The Center of Board Certified Fiduciaries at Wake Forest University, and serves as a volunteer to the CFP Board Professional Standards and Legal Department for complaints involving life insurance. Barry has authored numerous articles for national publications on managing life insurance as an asset according to established and proven asset management principles and frequently teaches continuing education courses about the same to attorneys, CFP®s, CPAs, and CTFAs.