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Can You Outsmart Uncle Sam?

by smeneshi - Feb 23, 2017

Life insurance is one of the most tax-efficient and versatile yet underutilized financial planning tools available. While most people view life insurance as only something that is needed when raising a family, its uses are many and varied. In fact, the right type of life insurance, if structured properly, can help address a number of issues such as high income taxes, long-term care and providing for a special-needs child.

In general, there are two types of life insurance:

  • Temporary (or term) and
  • Permanent

As for permanent insurance, there are several types: whole life, universal, variable, and variable universal.

The major difference between term and permanent policies is for temporary policies to pay off, you have to die within the term of the policy. For example, a 30-year old who buys a 20-year term policy must die before he turns 50 for the policy to pay the death benefit to his beneficiary.   So for a young and growing family whose budget may be tight, term policies insuring the lives of mom and dad could make the most sense. That’s because with term policies, you are only paying for life insurance coverage for a certain number of years i.e. on a “temporary” basis and you’re only funding a life insurance benefit.

As for permanent insurance, while you are paying for the death benefit, there is a savings component built into the policy that is meant to build up over time (depending on how the policy is structured). This savings component is called the “cash value” of the policy. As long as the premiums are paid or until the policy is “paid up” your beneficiary or beneficiaries will receive tax-free insurance proceeds upon your death. In fact, if your cash value has built up substantially, you can even direct the insurance company to pay the policy premiums directly from the cash value itself.


Since we’re in the middle of tax season, it would be remiss of me not to mention the major tax benefits associated with life insurance. For starters, when the death benefit is paid to the beneficiary or beneficiaries of the policy, the proceeds are received income-tax free (rare exceptions do exist, however). So for a widow or widower raising children, 100% of the proceeds can be used for paying off a mortgage, funding college education, paying for daycare, replacing lost income, etc.

While term policies have only one tax benefit, which is tax-free proceeds permanent policies have much more to offer.


Tax-Deferred Growth

Depending upon the type of permanent policy, you could have guaranteed growth of your cash value. Growth could also be tied to an underlying market index or company dividends may paid to policy owners. Regardless of the source of gain, any increase in the cash value above and beyond your contributions are tax-deferred just as with a 457 plan, 403(b), 401(k), or IRA.


Tax-Free Withdrawals

Withdrawals from the cash buildup are generally tax-free up to the amount of the policy owner’s contributions. Taking out distributions above the amount of your contribution will be taxed at ordinary income tax rates. Withdrawals are usually considered FIFO (first in, first out) so if your policy value is worth $20,000 and you contributed $12,000, then the first $12,000 that you withdraw from the policy is a return of basis, and therefore not taxed. The remaining $8,000, if withdrawn, would be subject to regular income tax.


Tax-Free Loans

Once a policy owner has built up a sizable cash value, he or she can borrow against the policy without the proceeds from the loan being taxed. That’s because a loan is different from a distribution since a loan has to be paid back. Of course, you’ll have to pay some interest, which is not tax-deductible, and if you default on the loan, then the proceeds will be treated as a taxable distribution. If there is an unpaid balance left on the loan at the time of death, the insurance company will subtract the outstanding amount from the policy’s proceeds.



So now that we’ve covered some of the technical aspects and tax benefits of life insurance, let’s examine some practical uses of permanent insurance.


Pay Income and Estate Taxes

If designed properly, your family can recoup all of the income taxes that must be paid on tax-deferred retirement plans. Remember, you don’t own all of your retirement plan balance – Uncle Sam is the owner of about 25-30% of your 457, 403(b), 401(k) and Traditional IRA accounts. Taking it a step further, if you structure your investments the right way, the interest and dividends from those investments can be used to buy a permanent life insurance policy so when you pass away, the proceeds can replenish whatever income taxes will have to paid to Uncle Sam from your retirement accounts.


Support a Special Needs Child

Parents of a child with special needs agonize over the quality of care their child will receive if they are no longer around to provide the care. By funding a special needs trust with the proceeds of a life insurance policy, the parents can properly secure the financial well-being of their child and dictate how their child’s care will be administered. The use of a special needs trust has the added benefit of not including the proceeds of the policy in the child’s estate, thus not counting against the child with respect to public aid.


Giving Efficiently

If you would like to leave a part of your wealth to a favorite charity, but also want to leave something to your child or children, life insurance gives you the leverage to make a meaningful impact on the charity, while leaving a good portion of wealth for your kids. Instead of leaving assets outright to a charity and the kids, one can buy a life insurance policy and name the charity and the kids as the beneficiary. This allows the policy owner to spend his or her wealth down to the last penny, yet still give to charity and leave something for the kids. In other words, spend it if you got it and leave the insurance proceeds for everyone else.  If you’re worried about spoiling the kids or are concerned the money will be spent all at once, then funding an irrevocable life insurance trust is an option to consider.


Long-Term Care

The sale of traditional or “pure” long-term care policies have dropped significantly over the past fifteen years and the major reason is because of the “use it or lose it” nature of many traditional LTC policies. Just like any other type of insurance policy, if there is no triggering event, then the policy won’t pay out. If you paid tens of thousands of dollars into a long-term care policy over the course of two or three decades and you pass away without needing long-term care, your policy premiums are not recoverable (although exceptions do exist). “Hybrid” polices – life insurance with long-term care benefits, allow the policy owner to turn the death benefit into a living benefit if long-term care or chronic illness care is needed (depending upon the terms of the policy).   Hybrid polices effectively solve the “use it or lose it” conundrum that has plagued so many people who know they need LTC protection but fear they won’t recoup their payments. That is because if long-term care isn’t needed, then the beneficiary or beneficiaries get pay the entire death benefit. Any of the death benefit used for long-term care typically reduces the policy’s proceeds.


Income Planning

A major issue for many in the public and non-profit sectors who have a pension and retirement savings is the potentially high tax bill that will be due on retirement plan withdrawals. The proper structure and funding of a life insurance policy can actually help to reduce income taxes in one’s estate. For example, a policy owner can enjoy either a guaranteed or non-guaranteed return and provided the cash value builds up sufficiently, instead of taking big distributions from a 457 plan, 403(b) or IRA, withdrawals from your policy’s basis or policy loans can be made instead. No income taxes would be due and if planned carefully, retirement plan balances can be passed onto the kids at a potentially lower tax rate. If your wish is not to leave money to the kids, then the tax bill due on retirement plan withdrawals can be paid for with tax-free loans from the policy.



There are a number of advantages that accompany permanent life insurance policies. The policy’s cash value can be used for paying off the mortgage, funding a child’s or grandchild’s college education, efficiently pay taxes, protect against long-term care, etc. As an added benefit, for those needing money before the age of 59 ½, there are no early withdrawal penalties unlike most retirement accounts. Additionally, required minimum distributions (RMDs) are not compulsory.

While receiving a tax-free death benefit is certainly attractive, there are a number of other advantages that permanent life insurance can provide to you and your family whether one is still living or has passed away. Understanding how the numerous features of permanent life insurance policies can be used and leveraged to help with financial and estate planning goals can alleviate some of the lifestyle concerns that are top of mind for most people.


Securities and advisory services offered through Ausdal Financial Partners, Inc.  Member FINRA/SIPC 5187 Utica Ridge Road Davenport, IA 52807    563-326-2064  Public Retirement Planners, LLC and Ausdal Financial Partners, Inc. are separately owned and operated.

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