09 May More About Whole Life

How Can I Get Tax-Free Income on Whole Life Insurance?

Life insurance is one of the best ways to provide for your loved ones after you’re gone. With a strong life insurance policy, you can leave your beneficiaries a tax-free windfall to help them deal with your funeral costs and continue living comfortably following your death.

However, the taxation requirements of life insurance can get quite complicated, and many people struggle to figure out how a life insurance plan can affect their taxes — both today and in the future. The two main types of life insurance are whole and term. Depending on which one you choose, your tax obligations will vary.

Whole Life Insurance vs. Term Life Insurance: What’s the Difference?

Before we dive into taxation, we should quickly outline how whole life insurance differs from term life coverage. A whole life policy is the most common form of this insurance and it provides coverage until you pass away, regardless of how long you live. In addition, these plans can also provide tax-free funds for other expenses as you age (more on this shortly).

Meanwhile, term life insurance provides coverage for a predetermined time period. Typically, these policies cover you for periods of at least one decade, and they often last as long as 30 years. Term life insurance only provides payouts to your beneficiaries if you die during this term. For example, if you purchase a 20-year term life insurance policy and you die 18 years later, your loved ones will receive the full benefit. However, if you last even one day beyond that 20th year, the policy simply expires with no payout.

Term life insurance is generally a good purchase for younger adults who want to make sure their families will have enough money if they pass away unexpectedly. For instance, new parents might want to buy a 20-year term life insurance plan. That way, if they pass away before their child reaches adulthood, there will be plenty of money for the child’s new guardian to raise them.

Or, a married person might purchase a term life policy to last until their expected retirement date. This way, their spouse can continue the same standard of living even without their partner’s income. In other words, term life insurance is structured in a way that only provides coverage while it’s necessary. If you plan your term life policy correctly, it will expire at roughly the same time as your loved ones’ need for the policy ends.

Meanwhile, whole life insurance covers you until you die, regardless of when that happens. There are quite a few other differences between these two types of policies as well. With whole life insurance, your premiums will not change at any time — instead, you will pay the same amount every month until you pass away. In addition, because you’re covering your “whole life,” these policies include a guaranteed death benefit. As we already discussed, a term life policy only pays a death benefit if you pass away within a certain timeframe.

However, whole life insurance policies have many other interesting attributes compared to term policies. You can take out loans from a whole life policy, and you have the choice of repaying those loans or simply reducing your eventual death benefit. You can also trade in the policy in return for an immediate cash payout, which is known as “surrendering” the policy. Of course, if you surrender your whole life insurance plan, your coverage ends.

A whole life plan also includes the “cash value” component, which provides policyholders with an investment opportunity. The cash value component is tax-deferred, so it will gain interest without generating taxation requirements on the profits. With some whole life insurance policies, you can even earn dividends each year, and you have several options about how you want to use them. Some people will simply use their dividends to buy more whole life insurance coverage, which can either decrease your annual premium payments or increase your policy’s death benefit.

This is just the tip of the iceberg when it comes to the financial benefits (and responsibilities) of a whole life plan, so let’s dig a bit deeper. As you’re about to find out, there are plenty of advantages and disadvantages to using a whole life insurance policy as a tax-free income source, and most of them rely on how responsibly you use the policy’s liquidity.

How Is Whole Life Insurance Taxed?

There are some taxation advantages of whole life insurance, but there are also some potential problem areas you should try to avoid. Let’s begin with the advantages.

Taxation Benefits of Whole Life Insurance

The biggest tax advantage is the way a whole life policy provides your beneficiaries with an entirely tax-free death benefit. Every dime you pay in premiums will be distributed to your loved ones when you die, and they won’t owe a penny in taxes. To be clear, this is also the case with a term life policy, but only if you pass away during the coverage period.

Another appealing aspect of a whole life insurance plan is the way you can enjoy tax-free loans from your policy. On the simplest level, you can take these loans out from your policy’s death benefit. You can either pay these loans back or opt for a reduced death benefit. This can be a great option for people who end up needing additional income in retirement, as long as you’re comfortable with the tradeoff of a smaller death benefit for your loved ones (or you can pay back the loans using other income).

Taxation Risks of Whole Life Insurance

The most significant problem faced by whole life insurance policyholders when it comes to taxation is the fact that your policy can actually become taxable if you manage it incorrectly. For instance, your policy may become taxable if you fail to consistently pay your premiums, or if you surrender the policy in exchange for an immediate cash payout.

However, this is just the beginning of the potential tax issues of a poorly managed whole life policy. That’s because any of the tax-deferred loans you may have taken out against the policy lose that tax-free status if the amount you owe ever exceeds the value of the policy. If this happens, you will either need to fund the policy with more money, or your insurer can cancel your policy.

Let’s illustrate this concept with an example. Assume that your policy has a $50,000 cash value, and you take out a loan of $45,000 against that cash value. Let’s say you’re also paying interest on that loan using the policy’s remaining cash value of $5,000. If your loan accumulates in excess of $5,000 in interest, your interest ($5,000+) plus the original value of your loan ($45,000) will exceed the policy’s original $50,000 cash value.

Why would this matter? If you find yourself in this position, you have two choices. You can deposit more outside money into your whole life insurance policy, or you can let the policy lapse. If you let it lapse, the Internal Revenue Service (IRS) will consider your loan to be 100% taxable.

As we mentioned briefly earlier, another scenario that would revoke the whole life insurance policy’s tax-deferred status is failing to consistently pay premiums. Whole life coverage is typically quite a bit more expensive than a comparable term life policy. If you get in over your head with premiums you can’t afford, your policy will likely lapse. If this happens, you lose your guaranteed death benefit. Therefore, you never got to benefit from the policy’s tax-deferred status at all, and you likely should have purchased a more affordable term life insurance policy instead.

Whole Life Insurance Policies as Retirement Investments

People are always looking for more tax-deferred retirement investment options, especially considering that IRAs and 401(k)s have strict contribution limits. In 2021, investors are limited to just $6,000 of annual investments into an IRA, while 401(k) plans limit contributions to $19,500. If you’re at least 50 years old, these limits expand to $7,000 for IRAs and $26,000 for 401(k) accounts.

In addition, IRAs have limits on who can invest in them as well. For instance, if you’re a single filer and you have a retirement account like a 401(k) at work, your IRA contribution allowance will phase out between $66,000 and $76,000 for a traditional IRA in 2021. If you make more than that, you’re out of luck. Meanwhile, if you have a Roth IRA, your ability to contribute to this account phases out if you make at least $125,000.

Due to these limits, many retirement planners want to be able to supplement their 401(k) and IRA contributions with other tax-deferred investments. After all, roughly 75% of Americans save too little money for retirement, and it’s advisable to do everything you can to put yourself in that other 25%. That’s why investment products like annuities have become so popular, and this applies to whole life insurance policies as well.

However, generally speaking, whole life insurance policies don’t provide much in the way of returns, especially compared to other forms of retirement investments. For the most part, a whole life insurance plan’s cash value component only pays interest rates of up to 3%, and often considerably less. It’s quite difficult to find whole life policies that provide more growth potential than this.

Therefore, in many ways, a whole life insurance policy is not a great vehicle for retirement investing. You can get better returns elsewhere. On the other hand, if you view taking out loans against a whole life insurance plan as a form of fixed-income investing, it becomes more appealing. After all, it’s unlikely that you’ll ever find a traditional savings account or CD that earns 3%.

As long as you remain vigilant about not borrowing more than your policy’s cash value is worth (including interest), taking loans against a whole life contract can be a relatively risk-free endeavor. However, this is only ever advisable if you’re a disciplined investor with plenty of other income sources who won’t give in to the temptation to dip into the policy for emergencies or unexpected expenses.

In Conclusion

We’ve shared quite a bit of information about the tax benefits and penalties of whole life insurance policies, so let’s quickly recap the most important points. First off, your policy’s death benefit is free of income tax responsibilities, which is a tremendous benefit for your loved ones. With just about any other form of retirement investment, the IRS will take their cut before the rest of it gets distributed to your beneficiaries.

In addition, the accumulated cash value of your whole life insurance policy grows in a tax-deferred manner as well. Especially as time goes on, and the cash value of your policy increases as you pay your regular premiums, this can turn into a significant advantage — even considering the relatively low returns.

Finally, any loans you take out against the cash value of your whole life insurance policy are untaxed until you exceed the policy’s cost basis (the amount you pay in). However, as we illustrated earlier, taxation is just one of the potential problems that could arise if your loans and interest combine to exceed the cost basis.

Overall, it is definitely possible to get tax-free income from your whole life insurance policy. However, you need to be extremely careful to not tap into your policy in a way that will increase its chances of lapsing. Especially considering how limited returns often are with whole life insurance policies, it simply isn’t worth the risk to leverage the account with too many loan withdrawals.

If you manage your policy responsibly, a whole life insurance plan can be a valuable source of retirement income and liquidity, with no tax obligations to worry about. However, if you manage your policy irresponsibly, you could turn this tax advantage into a massive disadvantage, triggering taxation penalties and potentially sacrificing your policy’s death benefit.