Taxes and Life Insurance

As we consider wise financial planning for ourselves and our families, one of the most fundamental building blocks is life insurance. Understanding the importance of life insurance and the role it plays in achieving financial independence is one thing. Understanding and navigating the tax laws that affect life insurance, however, is something else.

In our next few blogs posts, we’ll take a look at some of the common issues that arise with taxes and life insurance. A little careful thought and strategic planning can help you make the most of your life insurance.

First of all, let’s cover some life insurance basics.  At its essence, life insurance is a risk transfer mechanism, in that it shifts the financial risk of one’s death away from one’s family to a third party (the insurance company).  Life insurance alleviates the near impossible burden of amassing an emergency fund, early in life, that will pay off all outstanding debt and replace all your income sources through retirement.  Because the amount of life insurance needed to be adequately insured is usually quite large, term life insurance was introduced to provide less expensive premiums relative to its permanent insurance counterpart.  Term life insurance, as its name suggests, covers a “term” of one’s life, generally 10 to 30 years).  Most term life policies don’t pay out, as most people live beyond their working years into retirement.

For the majority of people in their working years, term insurance is the best choice to provide needed coverage.  For many, however, who have maximized all other tax-advantaged savings vehicles (401(k)s, IRAs, etc.), as well as those who have achieved financial independence and are now focusing on the ability to create tax-free wealth for their heirs, permanent life insurance is a dynamic tool that has virtually no rival.

Because of the investment-style benefits associated with permanent insurance, it is essential to realize that all life insurance contracts must meet state and IRS definitions of what is or is not really a life insurance policy.  Designed to combat past abuses of the tax-free nature of life insurance cash value, these definitions are meant to ensure that insurance policies are not simply investment vehicles “in disguise”.

How about some basic confusions surrounding life insurance, to start:  Remember that life insurance is considered a personal expense, so you can’t deduct your premiums. If you do access cash in the popular “loan” form, the interest paid on the policy loan is also not deductible. Furthermore, if you actually make a“withdrawal” in excess of the basis (the amount of premiums you have paid into the policy less any dividends or withdrawals you have previously taken), all of those proceeds are taxable.

Sound complex?  It is.  The tax laws for life insurance are pretty strict, and they continue to evolve.  Most of the issues, concepts and traps we’ll discuss deal solely with permanent policies, as opposed to term insurance.  It is in the permanent insurance arena where the IRS focuses its firepower to ensure that the insurance first serve as a security blanket against the financial burden of death.

In the next installment, we’ll look at a few specifics steps that you can take to avoid additional pitfalls and make the most of your insurance planning.

Ambassador Advisors is a Registered Investment Advisor. Securities offered through American Portfolios Financial Services, Inc. of Holbrook, NY, 631-439-4600 (APFS), member FINRA, SIPC. Investment Advisory Services offered through Ambassador Advisors, LLC. Ambassador Advisors is not owned or operated by APFS. To determine which college saving option is right for you, please consult your tax and accounting advisors. Neither APFS nor its affiliates or financial professionals provide tax, legal or accounting advice. Please carefully consider investment objectives, risks, charges, and expenses before investing. For this and other information about municipal fund securities, please obtain an offering statement and read it carefully before you invest. Investments in 529 college savings plans are neither FDIC insured nor guaranteed and may lose value.

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