How to Create a Tax Shelter With Life Insurance Contracts

Most people think of life insurance as a necessary evil, but with careful planning, life insurance contracts can create useful tax shelters. Whole and universal life insurance have three elements--life protection, administrative costs and cash value. Term life insurance has only the first two elements. In the past, many financial planners have encouraged clients to avoid whole life insurance, and buy term life insurance instead. The theory is that, by investing the difference in cost, the client will come out ahead. This advice doesn’t take into account the tax advantages of whole and universal life insurance contracts. Here’s how to use life insurance contracts as tax shelters.

Instructions

1. Understand that whole and universal life insurance is considerably more costly than term insurance. A portion of the higher premiums build cash value in the policy which grows each year because of the guaranteed interest that accumulates on the principle. This interest grows tax-free as long as it stays in the policy.

2. Recognize that term insurance is much less expensive , especially when the insured is young, but it becomes increasingly expensive as the insured grows older. Buying a 10- or 20-year level term policy helps mitigate this increase in cost, but any advantage in the savings requires a very disciplined savings plan to invest the difference consistently. Studies have shown that most people do not follow a disciplined savings plan successfully over many years, especially if they have to set up the savings plan themselves and put away a set amount out of their current income.

3. Consider the tax advantages of a whole or universal life insurance policy. The death benefit is usually tax-free to the beneficiary, just as it is with a term life policy. The cash value grows through the yearly addition of the cash component of the policy, as well as the compounding of interest on the principle, which grows tax-free in the policy. Most whole and universal life policies allow the insured to withdraw the cash value after a few years of accumulation. The IRS considers these withdrawals as a return of capital, making the money borrowed tax-free, even if the amounts withdrawn exceed the premiums paid in.

4. Realize that the benefit of withdrawing money tax-free from the whole or universal life policy has many advantages. Any amount withdrawn that exceeds the premium payments is treated as a loan against the policy and does not add to the policy holder’s taxable income. These loans do not have to be paid back during the life of the policy holder. They are subtracted from the death benefit once the policy holder dies., but the gains are not taxed. In addition, the policy holder may be able to avoid the estate tax by excluding the value of the policy from her estate with careful tax planning.

Tips & Warnings

• Unlike some other sources of tax exempt income, withdrawals from a whole or universal life policy do not trigger the AMT (Alternative Minimum Tax). This may be another tax advantage for those taxpayers whose main source of income is unearned (investment) income and who need additional cash in any given year.

• Not all whole and universal life policies offer these advantages tax-free. It’s important to select the right policy that pays the best interest rates on the cash value and to plan carefully to exclude the value of the policy from your estate. Consult your CPA to assist in this tax planning.