Whole life insurance and other forms of life insurance for cash value, enjoy many tax benefits that make them coveted financial products. These benefits are among other financial tools, but together they represent an impressive package of tax-friendly features that are worth a look. These combined benefits are of particular interest to Americans in higher income tax brackets or individuals with more than just a few thousand dollars in assets (especially when those assets are valued or held in eligible accounts).
Today we are going to go through the many tax benefits of owning full life insurance.
Tax deferred cash value accumulation
The cash value that grows in an insurance policy causes it to defer tax. This means that when the account balance grows every year, the insurance owner will not be liable to tax on the change in his / her account balance.
For example, suppose you currently own an entire life policy with $ 1
This function in life insurance differs considerably from other financial tools that create a tax liability for all value increases achieved during the year.
Think about your savings account. If there is $ 100,000 there at the beginning of the year, and the balance grows to $ 101,000 through interest income over the next 12 months, you will receive a 1099-INT at the beginning of the year that reports a taxable profit of $ 1,000. You will owe ordinary income taxes on these $ 1,000.
There is a significant merger benefit for tax protection over time. Since taxes are not paid on the growth unless you remove the profit from the policy (or cancel the policy), the profit will be continuously compounded in its entirety. Mathematically, this means that you will have a much larger account balance because you do not have to remove money each year to pay taxes due to the growth of funds within the policy.
The image below shows the difference in account balance growth between a taxable and deferred account over 20 years.
As you can see, the deferred account grows to a much larger amount after 20 years. Both accounts earn the same amount in terms of returns each year, but because the deferred account does not have a tax credit to pay each year, it can compound more dollars year over year.
FIFO Accounting Principle
Life insurance uses the accounting principle First In First Out (FIFO). This means that you can withdraw the money that you first contribute to your policy and the profit that is achieved through the other.
For example, suppose you had an entire life policy with $ 500,000 in cash value. You have paid a total premium of $ 300,000. You want to withdraw $ 50,000 from the policy. This $ 50,000 withdrawal is not taxable because you can take it from the $ 300,000 you have contributed to the policy.
You can actually take back all $ 300,000 from the policy if you want and there are no taxes on this because it was your money that you used to pay the insurance premiums.
Loans that are not taxable insurance
All life insurance with cash value has a function that allows you to access the money through an automatically approved loan issued by the insurance company
A life insurance loan does not count as income for you so there is no tax liability when you take out a loan against your police cash value. Police loans are a way that people get access to cash in their policy after removing the cost base and keeping the dividends tax-free.
For example, suppose you have an entire life policy with $ 1 million in cash value where you paid a total premium of $ 400,000. You have reached retirement and now want to use the cash throughout your life policy to generate some of your retirement income needs. You decide to deduct $ 60,000 per year from your policy. For the first six years, you can withdraw your cost base from the $ 60,000 revenue policy. From year 7, you remove the entire cost base so that the pension income you generate from the entire life policy starts using police loans to create income. By doing this for the time being, you ensure that your $ 60,000 per year income from the entire life policy remains tax free.
As long as the policy is in effect until you say you are dying, you will not owe taxes on the income you took from the policy.
Unique tax treatment of dividends
Dividends earned on an entire life policy enjoy a special tax benefit when taken as a cash dividend. Dividends for life come with a variety of options, and one of these options is to simply take the dividend in cash.
If you choose to do this, the tax law recognizes lifetime dividends as a refund of the premiums you paid. In other words, you can use the FIFO principle that applies to withdrawals for any dividends you take in cash from your policy. This protects certain dividends from being recognized as ordinary income to you.
So unlike the limited company's dividend that normally comes to you as ordinary income and accounting and income tax debt, you can get the whole life dividend tax-free provided that you have not exhausted the cost base for your policy.
Tax-free death benefit
In general, life insurance offers an income tax-free death benefit. This means that the death benefit paid on a life insurance policy goes to the beneficiary without any income tax impact for them. This has a subtle but significant significance when it comes to how the entire life insurance can create a significant tax-free savings and inheritance account for a policyholder.
Remember that all cash values in the entire life policy accumulate without immediate tax liability as the cash value grows Deferred tax.
If the policyholder does not deduct the profits generated by the cash value from the insurance but instead withdraws his cost base from the insurance and then uses the loan to access the cash value consisting of the profit, he / she will not owe any taxes on the money "distributed" from the insurance.
When the policyholder dies, the death benefit goes to his / her recipient without income tax debt who is neither the policyholder / insured nor the beneficiaries.  So this means you can build cash value into an entire life policy, either use FIFO withdrawals to base or insure loans to access the money built up in the policy without paying taxes for it, and then pass on the remaining death benefit to your heirs all without tax on any of the profits created by the policy. Whole life insurance is an essential way to build tax-free wealth.
The whole [Life] is greater than the sum of its parts
The various tax benefits of whole life insurance (and other forms of cash value for life insurance) are powerful on their own, but when combined in a neat package, the synergies become quite attractive. Sure, you can find one or two of the many tax benefits that whole life insurance has to offer among other financial vehicles, but you can not find them all together in any other available financial product.