How Do Life Insurance Tax Benefits Compare to IRA’s/401k’s?
“Be sure you know the condition of your flocks, give careful attention to your herds; for riches do not endure forever, and a crown is not secure for all generations.“ (Proverbs 27:23-24)
When the US government changed the Constitution to make legal the income tax, they applied it to certain types of income. Over the years, the way the government has applied these taxes has changed, but one thing that has never changed is that the cash value growth and dividends within a permanent life insurance policy are not taxable. There are however exceptions to this – which we will get into below.
So the taxation, practically speaking, works in much the same way as a Roth IRA, but with more flexibility. Money that is put into the plan does not affect your taxes in the year that it is saved. It grows tax deferred, and if utilized correctly will never be subject to income taxes. Because life insurance is first and foremost a way to pass money on after you are gone, it has never been taxed.
So what does it mean to utilize the policy correctly? The benefits are not taxed because it is life insurance. If you ever decide that you no longer want the life insurance and you cancel the policy and walk away with your money, the IRS will see this is a taxable event because it will appear that you never really wanted the life insurance, you were simply trying to get the tax free benefits. But this would not be a wise move anyways since by this time your policy would be performing so strongly that it would make no sense to cancel it. You would already own all the future benefits and dividends, why turn away from them?
As cash value is building within the policy (both from guaranteed cash value and dividends which we’ll discuss tomorrow), you can always withdraw up to the amount that you’ve put into the policy without any taxes being assessed. After this point, you can access the cash value by taking a loan from the mutual company using your cash value as collateral. We’ll discuss accessing your cash value in a future post, but this is our preferred method because of the opportunities for additional velocity.
Of course, if it makes more sense in a particular scenario, you can withdraw your cash past the point of your cost basis (what you put into the policy) and are then subject to taxes which you have been deferring. So, even if you choose to pay the taxes, you have the benefit of deferring them until you want the money, without the normal consequence of giving up control and access to the money. However, most people prefer to avoid paying the income taxes all together, which is easy enough to do.
It’s also good to know that when the life insurance benefits pass to your heirs or charity of choice, there will not be any income tax on this money, either. However, it could be subject to Estate Taxes, depending on your situation.
Long story, short, Whole life gives you the tax advantages of a Roth IRA without having to give up control over your money (or limits on whether or not and how much you can put in).
We’ll discuss the way the cash grows within the policy tomorrow.
This is Part 1 in a series on Whole Life Insurance. You might want to read the introduction to this series which will link to each post in the explanation of whole life and Ben’s story showing how whole life is used in a variety of ways in his life.
Photo credit: J Kenna Photography