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The 6 Forgotten Middle-Class Tax Breaks of Life Insurance

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What You Need to Know

  • Life insurance can help clients cope with costly life events.
  • In good times, the value of a permanent life policy keeps growing.
  • The IRS usually leaves that value be.

In a pandemic impacted world, it is becoming increasing known that life insurance should be one of the building blocks of an individual’s personal financial safety net.

When properly purchased and structured, life insurance delivers cash, on a guaranteed basis, in the future when it is needed to help pay the costs of unexpected life events such as death, disability, chronic illness or a long-term care need.

Despite these inherent benefits, most consumers and some advisors have forgotten that life insurance has a number of tax breaks that are focused on the broad middle class. These benefits don’t pop out when an annual Form 1040 is completed, but they are real and add up to significant tax advantages for the consumer.

This month is Life Insurance Awareness Month, and it’s a good time to talk to consumers about both the obvious benefits and the benefits that help policyholders build wealth.

Here are the top six tax advantages, in my view.

1. No Limit on the Amount Purchased

In comparison to qualified plans, there is no limit on the amount of life insurance that can be purchased subject only to the underwriting limitations of issuing life insurance carriers.

Using cash value life insurance as a tool to save for the future and to generate supplemental retirement income are valuable benefits in a world where households need to save more as corporate pension plans disappear.

2. Tax Deferral on Earnings

Permanent life insurance policies can generate cash value over time as premiums are paid and excess cash beyond the policies’ cost is generated. All cash income earned is not taxed currently and is able to earn interest on the taxes not currently paid. As we face the prospect of increasing future income tax rates, this benefit could become even more valuable.

3. Income-Tax Free Death Benefit

One of the most forgotten tax benefits of a life insurance policy is that the death benefit is income-tax free. Beneficiaries receive the policy’s death benefit, usually in a lump sum, and don’t have to report the payout as taxable income.

They can use it as they please. The fact that the payment is received without any federal or state income taxes multiplies its value to the beneficiary.

4. Tax-Advantaged Access to Cash When Needed

Most potential buyers don’t understand that permanent life insurance policies have contractual features that allow the owner of the policy to withdrawal cash from the policy using tax-advantaged loans and withdrawals.

Money borrowed or taken from the cash value of a life insurance policy is generally not subject to income taxes up to the “cost basis” — the amount paid into the policy through premiums.

Also, there are no regulatory restrictions on how the cash taken from a life insurance policy must be used by the owner. This creates significant flexibility to use the cash to fund a variety of needs, be they health or personal needs, such as putting on a new roof.

5. Supplemental Source of Tax-Free Retirement Income

Policyowners can withdraw or borrow against the value of their permanent life insurance contracts for any need, like supplementing their retirement income. If this benefit is used, the policyholder needs to clearly understand that tapping a life insurance policy’s cash value decreases the remaining cash value as well as the death benefit.

6. Tax-Free Way to Leave a Legacy

Life insurance can be used to create an income tax-free legacy to beneficiaries using the income tax-free death benefit. For very large death benefits there is the possibility of triggering estate taxes, which must be planned.

Legacies can be created for family members, charities, religious organizations and educational institutions. This can allow individuals to benefit numerous entities using the leverage that the life insurance death benefit creates.

The key takeaway is this: When you read about tax advantages provided to the middle class, the benefits of life insurance are infrequently mentioned.

Life insurance offers significant tax benefits that provide families with protection, the ability to accumulate cash and leave a legacy to those they care about. We need to beat the drum louder to promote these intrinsic benefits.

(Image: Adobe Stock)


Harry N. Stout (credit: Stout)Harry N. Stout has been the president of Fidelity & Guaranty Life, deputy chief executive of Old Mutual Financial Network, and managing director of Insurance Insight Group. He is also the author of The FinancialVerse personal finance books and of a new book, Today’s Life Insurance — A Protection Tool for Your Future.