• Harry N. Stout

268- The Six Forgotten Middle Class Tax Breaks of Life Insurance


In a pandemic-impacted world, it is becoming increasingly 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, many consumers 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. Here are the top six 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.


Summary

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. It can pay to understand exactly what the tax advantages life insurance offers.

 

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