Unlike visions of dancing sugarplums or unsanctioned backyard fireworks displays – images of more pleasant annual rituals – tax season too often means lost receipts, stressed accountants and mountains of paperwork. While it’s hardly considered fun, tax time does afford advisors an opportunity to discuss effective tax reduction and estate planning strategies. Fresh from pricking their finger and writing the check to Uncle Sam, clients are more open to advisor suggestions than at any other time of the year.
Traditionally known for safety and security features, life insurance is a core element of a number of tax-reduction strategies. However, New York-based research firm Ipsos Insight found that education on the subject is sorely lacking, which provides senior advisors with an excuse to get in front of clients.
In 2004, the estate tax contributed close to $24 billion to federal government coffers. Despite this sizable sum, fully half of the respondents to a recent Ipsos survey didn’t know that life insurance can help alleviate the estate tax burden. If Congress repeals the estate tax, 57 percent said they are likely to invest more in order to build a larger amount to pass on to their heirs. Conversely, if Congress does not repeal the estate tax, 48 percent said they are interested in purchasing additional life insurance. In either case, professional guidance is needed, representing a win-win situation for advisors.
“We’re motivated by the fact that we continually see life insurance sold for the wrong reasons,” says Steve Temple, principal with Springfield, Ohio-based Senior Advisory Services Group. “Too often the question is asked, ?How much do you love your family?’ [With that, advisors are] trying, in essence, to guilt the client into purchasing insurance he might not need.”
Temple believes too many seniors have been misinformed on life insurance during the accumulation stage. One recurring myth he encounters is that people don’t need insurance as they grow older, which he believes is the wrong way to look at the situation. He explains that they’ll have tax and estate planning issues, as well as expenses related to the settling of the estate itself, with which life insurance can help.
According to Cincinnati-based WM Financial Services, specific tax advantages include the following:
? Tax-deferred growth – It may be obvious, but it doesn’t hurt to remind clients that most life insurance policies that build cash value grow tax deferred through earnings and interest. Tax-deferred growth especially benefits clients in high tax brackets. Additionally, if the life policy pays dividends, income tax is due on the dividends only if the amount received is greater than the premiums paid. Additionally, dividends are only taxable if taken in cash. If dividends are used to buy additional life insurance, taxes do not apply.
? Tax-free access to the policy’s cash value – In certain situations, access to some or all of the cash value in the policy is available without paying current income taxes. This can be accomplished in one of two ways. First, if the policy is canceled, the cash-value proceeds are received outright. Again, income tax applies only to the amount that exceeds premiums paid. Secondly, a loan can be taken against the cash value within the policy. Many policies let the owner borrow up to 90 percent of the cash value while the policy is active. If a loan is taken, income tax is not paid on the borrowed amount, but interest will be paid to the insurance company. If the loan is not paid back before the death of the owner, the amount will be deducted from the death benefit paid to the beneficiary. If a policy is canceled with a loan still outstanding, taxes and penalties may apply.
? Tax-free death benefit – The taxes associated with a life insurance death benefit can be confusing. WM Financial found many clients assume that a death benefit is always completely tax free. A death benefit is free of income taxes. However, if the policy is held in the deceased’s own name, the death benefit will be counted as an asset of the gross estate and may consequently be subject to federal estate taxes.