Although people buy life insurance policies to pass on a financial benefit to their loved ones, the money can be used for other purposes. Additionally, a life insurance policy can also be a great living benefit for the policy owner as a financial product, with savings and tax advantages built into the policy. These benefits underscore the fact that not everything about life insurance concerns death.
The main purpose of a life insurance policy is to provide financial security for your family, but the money can be used for many purposes after you pass away. It can pay for the funeral expenses, which can build up to $10,000. The death benefit can pay for estate taxes, pay off debt and provide money for estate administration. As far as financial security, the money can help with unresolved monetary responsibilities that the deceased left behind, such as house, car or any other loans, credit cards and other expenses. It can also fund your children’s college expenses.
Whole life insurance policies provide a cash value account, which takes some of the premiums you pay and transfers them into an interest bearing account. Over time, this money can add up based on the investment performance of the company. Some of the returns on the cash value account exceed the amount you receive from a traditional bank account. Although a life insurance policy isn’t an investment tool, it can be used to finance a retirement, pay for vacations and purchase big-ticket items such as a house, car, medical expenses and your child’s education while you are alive. Keep in mind that the money you withdraw is called a policy loan and although it isn’t required to be paid back, it will drop your death benefit and cash value by the amount of the outstanding loan. If you do decide to pay it back, it is on your terms.
When the beneficiary receives the death benefit from a life insurance policy, the money is free from income tax. The money that is accumulating in the cash value account is also tax free. If you decide to borrow against your policy by receiving a policy loan, the money will not be subject to taxation. However, your policy proceeds can bump your estate value above the federal threshold and trigger a tremendous federal tax hit--as much as 55 percent. The easiest way to avoid estate taxes on your policy is to assign it to another owner, such as the beneficiary, who isn’t named to your estate. As long as it is outside your estate at the time of your death, the policy is safe.
Funding a life insurance policy with its tax free, interest-earning cash value account can reap great rewards. However, those who try to be greedy must be warned that there are limits to how much you can put into a policy. Excessive funding of your life insurance policy would cause it to become a modified endowment contract (MEC). For your policy not to be considered an MEC and subject to heavy taxation, your premium payments must not exceed the average annual amount over a seven year period. For example, if you have a $70,000 policy and you put in $10,000 each of the first two years, and then put in $15,000 in year three, you would have exceeded the average payment and violated the life insurance agreement. Now, using the same example, if you put in $5,000 over the first two years and then put in $20,000 in year three, that is within the limit of $10,000 per year, and your policy wouldn’t be considered an MEC. The IRS allows policy owners to ‘catch-up’ on their payments, but not exceed them.
Using a cash value account from a life insurance policy as a savings vehicle can be a better option than a traditional savings account. Although frequent withdrawals from your policy are not recommended due to the risk of passing away with a lower death benefit, the tax advantages, rates of return and the solvency of most life insurance companies make it a safer investment. What’s ironic is that banks put their money in, that’s right, a life insurance policy! Banks are reported to have put as much as 25 percent of their top tier capital into BOLIs (Bank Owned Life Insurance) policies.