How to Reduce Your Taxes Using Life Insurance
If you think that taxes are going to be higher in the future, you might want to start thinking ahead. Life insurance is an excellent tax planning tool if used properly. Funding a permanent life insurance policy that is structured for efficient cash value growth could allow you access to tax-free withdrawals in the future. If tax rates increase in the future, using life insurance to fund part of your retirement plan could save you thousands in taxes. In this post we will explain how to reduce your taxes using life insurance.
The Case for Higher Marginal Tax Rates in the Future
If you take a look at historical marginal tax rates in the U.S., you can see that we are actually close to historical lows. Rates have increased in the past when the government was subject to higher expenditures. This is obvious during events such as World War II. In fact, since 1950 the government has pretty much run at a deficit very year with the exception of a few years at the end of the 20th century.
The Case for Higher Tax Rates in the Future
Source: Tax Foundation, January 2015
Unfortunately, we are now at a point where shortfalls in programs such as Medicare and Social Security could push the government to tax rates to rise in the future. Where else is this money going to come from? Considering that we are near the lows of historical marginal tax rates, there is room to for tax rates to rise.
Tax Deferred vs Tax Free Options
Two popular tax-deferred investments are the 401K and traditional IRA. Most people who save for retirement contribute to a company sponsored program like a 401K. You can also fund a traditional IRA if your modified adjusted gross income is below a certain level. Programs such as a 401K and IRA allow you to invest pretax dollars that grow tax-deferred until retirement. You pay taxes when you pull the money out at retirement. There are annual limits to the amounts that can be invested in both a 401K and a traditional IRA. These types of accounts are a great option for most, especially if your employer offers some 401lK matching benefit. Unfortunately, paying taxes later rather than now could be an issue if tax rates increase in the future.
A Roth IRA is funded with after tax dollars. Because you have already paid the taxes on your Roth IRA contributions, you can take tax-free withdrawals at retirement. There are income and contribution limits for a Roth IRA also, but a Roth IRA could be an excellent option if you think that tax rates will be higher in the future. With a Roth IRA, you are essentially paying the taxes now rather than deferring them to sometime in the future.
Life insurance also offers the potential for tax-free withdrawals in the future. By making premium payments with after-tax dollars, your cash value can grow tax-deferred and you take tax-free withdrawals from your policy in most cases. There are no limits to how much you can invest in a life insurance policy, unlike IRAs and 401Ks which have annual limits. Along with the ability to build cash value, life insurance will also provide valuable protection to your loved ones if you were to pass away.
How Can Life Insurance Used for Cash Accumulation?
You can use a number of different types of permanent life insurance to fund this strategy. You can pretty much use any of the wide range of whole life or universal life products available on the market today. The key is policy design. A permanent life insurance policy should be structured in a specific manner in order to maximize cash value accumulation. In order to maximize cash value, you should pay the highest premium for the smallest death benefit allowable by the IRS. It is very important to follow the IRS guidelines for funding a life insurance policy. If you fail to do so, your policy will be considered a modified endowment contract (MEC) and it will lose its tax benefits. The good news is that life insurance illustration software will take this into consideration when calculating values. Paying a higher premium while suppressing the death benefit will keep your cost of insurance low, allowing more of your premium to move to your cash value. You can structure your policy so that you pay in for a set amount of time such as 20 or 25 years. For instance, you can fund a policy from age 40 to 65 and start a stream of income shortly thereafter in retirement.
Building Cash Value
If properly designed to maximize cash value, a life insurance policy can accumulate funds that can be used in the future for retirement or other purposes. The cash value in a life insurance policy grows tax-deferred and can be withdrawn tax-free in most cases. You can choose conservative growth strategies using whole life insurance and traditional universal life insurance. You can also use more aggressive growth strategies by utilizing variable or indexed life insurance where returns are tied to the stock market. If you think that taxes will be higher in the future, funding a life insurance policy could make a lot of sense.
Flexibility of Life Insurance Compared to IRAs and 401Ks
Again, there is no dollar limit to what can be contributed to a life insurance policy so you are allowed a bit more funding flexibility compared to other accounts such as 401Ks or IRAs. Accounts such as a 401K or IRA also have age restrictions for withdrawals called the 59 ½ rule. Withdrawals from these accounts before age 59 ½ will trigger penalties on top of taxes. Life insurance does not have any such age restrictions.
Using Life Insurance to Reduce Your Taxes
This strategy is not for everyone. Using life insurance for tax planning makes more sense for high earners and those who strongly believe that taxes will be higher in the future. For high income earners who are unable to invest in a Roth IRA due to income limits, funding a permanent life insurance policy could make sense. For most others, looking at Roth IRA first is probably a better choice if you think taxes will be higher in the future. We can show you your options when it comes to using life insurance in your retirement plan. We have a completely objective view on this strategy and will help you choose the option that best fits YOUR goals.
About Us
Archstone Insurance Services, LLC is an independent agency that shops over 40 of the top life insurance carriers to provide huge savings on life insurance coverage for our clients. We are happy to answer any questions you might have about any of the insurance products we offer, your planning needs or your existing coverage. Feel free to call us directly at (888) 687-9444 or email us at info@archstoneagency.com.
