The Tax Advantages of Life Insurance

Most of us recognize life insurance as an investment vehicles that can provide financial protection to your family in the event of your death. However, did you know that life insurance also offers tax advantages? Learn how life insurance can play a role in helping you reduce taxes.

Basic types of life insurance
Before we delve into the tax benefits of life insurance, the two basic types of life insurance offered are permanent life insurance and term insurance. Of these two basic types, permanent life insurance, otherwise known as cash-value insurance, can offer potential tax benefits.

• Permanent life insurance provides coverage throughout your lifetime as long as the premium payments are paid on time and you don't cancel the policy. The premiums of a permanent life insurance policy remain relatively level while the policy is in force; however, the overall cost of such a policy can be very expensive.
  
  In addition, most permanent insurance policies offer a savings component which allows you to build up cash value from which you can borrow. Permanent insurance may be a solution if you want coverage for the long term and if you're seeking potential tax benefits.
  
  Learn more about the different types of permanent insurance that exist.
  
  
• Term insurance provides coverage during a specified period of time as long as the premium payments are paid on time and you don't cancel the policy. You purchase the term insurance for a specific number of years, during which your premium remains level (the policy may be renewed at the end of each term). If you die while the policy is in force, the term insurance pays the face value of the policy to your name beneficiary(s). Term insurance premiums increase significantly as you get older and can become very expensive.
  
  In addition, unlike permanent insurance, term insurance doesn't carry a saving component (i.e., it doesn't accumulate cash value). Term insurance may be an option for you if you're at a point in your life when you have the greatest need for life insurance, for example, when you have dependent children.

Tax-deferred growth of your money
Permanent insurance is a unique product in that it provides a death benefit protection along with the potential for tax advantages. The cash value that accumulates in the policy grows tax deferred, in other words, it's not subject to current taxation. This can be particularly beneficial if you're in a high tax bracket.

In addition, if you own a life insurance policy that pays you dividends (i.e., variable life or variable universal life insurance), you don't have to pay income tax on dividends if the amount you receive is less than the premiums you paid. However, you do have to pay income tax if you cash out on your dividends.

Another tax benefit to investment-based life insurance policies is that you don't have to pay income tax if you use your dividends to purchase additional coverage within your existing life insurance policy.

Tax-free access to your policy's cash value
Permanent life insurance can offer additional tax benefits in certain situations, for example, when you take out a policy loan, or if you want to cancel your policy.

• Take a policy loan. Many policies allow you to borrow up to 90 percent of the cash value in your policy. If you take a policy loan, you don't have to pay income tax on the amount you borrow (although you'll have to pay interest to the insurance company).
  
  If you die and have an outstanding loan, the amount owed toward the loan will be deducted from the death benefit paid to your beneficiary(s). Keep in mind that you may face taxes and penalties if your policy is canceled with an outstanding loan.
  
  
• Cancel your policy. If you cancel your permanent insurance policy, you can receive the cash-value accumulation from your policy. The cash value you receive can be tax free if the amount doesn't exceed the premium amount you've paid. Only the excess amount above the paid premium amount will be subject to income tax.

Avoid potential estate taxes
Taxes associated with a life insurance death benefit can be complicated. Death benefits for both term and permanent insurance are free of income taxes. In other words, your beneficiary will not have to pay income tax on the death benefit they receive.

However, a death benefit can be subject to estate taxes. If the policy is held in your name when you die, the death benefit may be counted as an asset toward your gross estate and may be subject to federal estate taxes. As a result, the death benefit your beneficiary receives could potentially be less than originally stated. How can you make certain your beneficiary(s) receive the full death benefit?

First, estates are taxed only if they're valued within a taxable range. For 2008, estates that are valued at more than $2 million are subject to estate taxes (this limit will increase to $3.5 million in 2009).

If your estate is taxable, you can avoid having estate taxes taken from your life insurance death benefit in the following two ways:

• Name your spouse as the beneficiary in your policy. If you're married, naming your spouse as the beneficiary in your policy could eliminate the estate tax burden since assets (regardless of amount) transfer between spouses free of estate taxes.
  
  
• Place your life insurance into an irrevocable life insurance trust. If your policy is owned by another entity, such as an irrevocable trust, it won't count toward your gross estate and therefore won't be subject to estate taxes.

To find a tax strategy that works for your financial situation, please consult your tax advisor.

Note: Any discussions of tax issues isn't intended or written to be used and can't be used to avoid taxes and penalties imposed by the Internal Revenue Service.

Choosing a life insurance policy
Choosing a life insurance policy that meets your individual financial situation is very important. No single type of insurance suits everyone alike. You'll need to consider your family's needs as well as the features within a life insurance vehicle that are most important to you. Consider life insurance to secure your family's financial future.

Need assistance in selecting a life insurance policy that's right for you? Our investment professionals can assist you with finding a life insurance policy that's suitable for your financial situation.

Find an investment professional at a WaMu financial center near you for a free consultation.