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How to Lower Retirement Taxes With Life Insurance


There are two main ways to use a permanent life insurance policy for retirement planning. The first is through cash value. You can take money from your policy’s cash account up to the amount of premiums paid tax-free. The second is through a loan. You can borrow against your policy’s death benefit tax-free. This loan will typically accrue interest over time. Here’s how it works.

A financial advisor can help you decide which type of life insurance could be a fit for your retirement plan.

What Is Permanent Life Insurance?

There are many types of life insurance policies, but the two broadest categories are permanent vs. term life insurance.

Term life insurance is, as the name suggests, a policy that covers you for a term of years. If you die during the policy’s coverage, the policy will pay out a fixed death benefit to your beneficiaries. For example, say that you take out a term life insurance policy for 25 years with a death benefit of $250,000. If you die during that 25 year period, your life insurance policy will pay out $250,000 to your named beneficiary. After that, the policy will expire.

Permanent life insurance, on the other hand, covers you for the rest of your life. It is, as the name suggests, permanent. The most common form of permanent life insurance is called “whole” life insurance. Whole plans are relatively simple policies that offer a fixed death benefit in exchange for fixed premium payments. Since a permanent life insurance policy will almost always pay out, unless something terminates or voids the policy, the premiums can be significantly higher than with term life insurance. 

Permanent life insurance policies also accrue a cash account in addition to the death benefit. With a permanent policy, a portion of your premiums are deposited in an interest-bearing account. This account grows the longer you hold the policy, as it collects both premium payments and interest. Term life insurance does not offer cash accounts.

Permanent Life Insurance Can Be Used for Tax-Advantaged Income

A senior researching how permanent life insurance can be used for tax-advantaged income.

Term life insurance cannot be used for income in retirement. You can use them for tax-advantaged estate planning, since your beneficiaries will not pay taxes on the death benefit they receive, but you cannot take money from this account.

However, permanent life insurance policies offer two ways to build tax-advantaged income in retirement: cashing out your account and taking a loan from it.

Access the Cash Account

The first option is to access your policy’s interest-bearing account. You can take money from this account tax-free up to the amount that you have paid in combined premiums, known as the account’s “cost basis.” All withdrawals above that, meaning the amounts that your account has accrued in interest, are subject to income tax.

For example, say that you have a permanent life insurance policy. Your policy’s cash account has $220,000 in it. Of this, $200,000 is from your premium payments and the other $20,000 is from interest. You can withdraw $200,000 tax-free from this account. If you take the remaining $20,000, it would be subject to income taxes.

There are some benefits to this approach. The biggest advantage to using a cash account is that it grows tax-deferred. This means that you don’t pay any taxes on your account’s interest payments while they accrue, in the same way that a 401(k) or IRA grows untaxed. Life insurance accounts also have no upper limit on your premiums and contributions. You can put as much money as you want in this account (but takenote: if the IRS considers an insurance account to be overfunded, it can reclassify the policy as a modified endowment contract, which changes the tax benefits).

This makes cash accounts a popular supplement to ordinary retirement savings. If you have maxed out your contributions to other retirement accounts, you can begin putting additional funds in a life insurance portfolio. 

There are three main disadvantages to this approach, however. First, by withdrawing money from your policy’s cash account, you reduce the value of your policy for your beneficiaries. When you die, your beneficiary receives both the policy’s death benefit and its cash account, so you should make sure that this approach lines up with your estate planning.

Second, unlike with a pre-tax retirement portfolio, you do not receive a tax deduction for money you put into your life insurance policy. These are post-tax investments. And third, this money will grow much more slowly than a typical investment fund. While the numbers vary considerably, on average a cash account will pay between 1% and 3.5% interest per year. While more than you would typically receive from a traditional bank savings account, it is far below the returns you could get from an S&P 500 fund or even a high yield savings account.

Borrow Against the Policy

With a life insurance loan, you borrow money instead of withdrawing it. In general, you can borrow up to between 80% and 90% of the value of your account, not just the cost basis. You do not pay any taxes on the money you borrow from your life insurance policy. However, you will pay interest on the loan while it is outstanding. The rate will depend on your specific insurance contract.

A life insurance loan is then repaid in one of two ways. If you choose, you can repay the loan and interest yourself. Otherwise, if your loan is still outstanding when you die, it will be repaid from your policy’s cash account and death benefits. 

For example, say that you have a policy with a $1 million death benefit and $200,000 in the cash account. Over the course of your retirement, you take out several loans from your policy. When you die, this loan is worth $300,000 in combined principal and interest. Your insurance company will take repayment from your policy, and your beneficiary will receive the remaining $900,000.

A life insurance loan can be a good way of getting tax-free cash from your policy, but it has a few catches. First is the expense. This loan will grow, as interest accumulates over time. Second, this loan will affect your estate planning. Unless you repay the loan from other sources of cash, it will be paid out of your policy, reducing the cash available for your heirs and beneficiaries.

Finally, be careful of letting this loan grow too big. If the accumulated loan and interest get too large, your insurer may cancel your policy. In that case, you may need to treat this money (in excess of your premium payments) as taxable income or repay portions of it all at once. 

Bottom Line

A woman researching how permanent life insurance policy can be a source of tax-advantaged savings and income for retirement.

A permanent life insurance policy can be a source of tax-advantaged savings and income for retirees. You can withdraw money that you have saved up in this fund, taking out cash that can grow tax-deferred year over year. You can also take a loan against the value of your policy, providing extra cash in hand when you need it.

Tax Planning Tips for Retirement

  • Taxes don’t go away just because you’ve retired. In fact, at this stage of life, smart tax planning can be more important than ever. Here are five tips for smart tax management in retirement.
  • A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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