The IRS advantages of life insurance
Life insurance protects your family’s financial future in the event of a tragedy. Without it, your family might face undue hardship. Life insurance can play a significant role in your estate planning and offer several tax advantages, including:
Tax-free death benefit
Your beneficiaries will not have to pay income taxes on life insurance proceeds whether your policy is worth $50,000 or $5 million. However, the death benefit could still be considered taxable, just in a different way.
If the deceased’s estate is worth more than $5.45 million, then an estate tax will be owed on any amount over that threshold. If you have significant assets or a large life insurance policy, your total estate could exceed that threshold. In that case, your heirs will owe estate taxes on the amount above the exemption.
If you think your life insurance policy might subject your heirs to the estate tax, a life insurance trust is worth considering. This trust lets you transfer ownership of the policy and name someone other than yourself as the trustee. Your trust — not you — must pay the premiums, and the trust must have been opened at least three years before your death in order for it to be considered valid.
By removing it from your estate, life insurance can pass to your heirs tax-free.
Accumulating cash value
Most people have a life insurance need for a set number of years, typically long enough to raise their children and get them through college. And for them, a term life insurance policy of 20, 25 or 30 years is probably adequate for their needs. But others need life insurance throughout their lives like parents of a special-needs child or someone who wants to leave a legacy to their heirs without worrying about preserving assets during their lifetime. For them, permanent life insurance might be a better fit because it covers them no matter how long they live.
Along with providing a death benefit, permanent life insurance also accumulates potential cash value. That’s because a portion of your premium goes into a cash value account that accumulates interest and earnings on a tax-deferred basis.
When you withdrawal from the account, you pay taxes only on the amount above what you paid into it. For example, if you paid $20,000 in premiums and the account is worth $25,000, only $5,000 is considered taxable.
Permanent life insurance also gives you the ability to take tax-free withdrawals as long as they’re structured properly. This sophisticated strategy can help you create tax-free income for retirement.
While you must pay taxes on withdrawals of more than the amount of your contribution from a cash-value account, the IRS allows you to take loans from the account tax-free. As long as you keep your policy active (by paying the premium), you never have to repay the loan or pay taxes on the amount.
However, if you should die with an outstanding loan that amount will be deducted from your death benefit, and your heirs will receive the difference between your death benefit and your loan.
Life insurance should always be about protecting the ones you love. But it’s good to know that the IRS has some tax-friendly ways to help you maximize the value of that protection.