Making certain that a family can make it through the death of its bread-winner is the main purpose of life insurance coverage. Over the years, Congress has granted life insurance numerous tax shelter characteristics that raises its usefulness as a store of value--for retirees also. Let's see which tax shelter aspects you could use.
Like any tax shelter, life insurance can save on income taxes for you or your beneficiaries. It can likewise bypass estate taxes (with proper estate planning) while you provide wealth to your loved ones.
To begin with, life insurance is available in two basic types-- permanent and term. Both provide a death payoff to a designated person upon the death of the insured. Only permanent life insurance coverage builds a store of value translatable into cash. Permanent life insurance includes whole life, universal life and variable life-- the latter 2 preserving their store of value in market investments and also supplying a couple of tax shelter elements as we clarify below.
Tax Shelter Aspect of the Death Benefit
Producing a legacy through life insurance is primarily done through the death benefit payout. And there is no restriction to the size of the death benefit you may create (as a practical matter, life insurance companies will only issue policies up to a size commensurate with your overall wealth). The tax shelter is that your beneficiary receives the death benefit free of income tax (as long as the policy is not in the insured's estate). As opposed to other tax shelters, the intergenerational exchanges of other tax-advantaged investments eventually need you or even your beneficiaries to pay tax on the earnings. See table summary.
|Cash value of
Life insurance policy
|Affect social security tax:
|Yes if portfolio
|Tax free access to cash value:
|Yes, by loan
|Taxed access to cash value:
|Yes , by surrender
Tax Shelter of Permanent Life Insurance's Store of Wealth
As opposed to other tax-advantaged opportunities, there is no limit on the store of wealth you can have in your life insurance - through growth or contributions. When you have maxed out contributing to other tax-advantaged possibilities (e.g. IRAs, 401ks), you can add to the cash value of your life policy.
Like other tax shelter opportunities, your life contract cash value grows tax-deferred making a tax shelter throughout your life time. One benefit of life insurance savings is that its earnings won't have an effect on your social security taxation (per present tax legislation) as do other forms of income. Interest and dividends, as well as tax-free interest on municipal bonds, could drive up your social security taxation if your income is sufficient but never the earnings accumulated or borrowed from a life policy.
In case your life insurance value is allocated over investment sub-accounts (e.g. a variable life policy), you have a tax shelter when re-balancing these accounts as you pay no tax on any gains from sales as you move money from one investment to another. To compare, you would pay tax on gains when re-balancing mutual funds.
While you are living, you have access to the store of value of the life coverage policy as most every life policy allows you to borrow from it - a tax sheltered source of cash.
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