Life Insurance Strategies that Save on Taxes

Understanding the fine print is crucial.

With the passage of the SECURE Act, life insurance has become even more attractive as an overall financial-planning tool. For instance, with the elimination of the “stretch IRA”—which allowed traditional IRA beneficiaries to access funds over a long period of time in order to reduce the impact of taxation—life insurance proceeds can help to replace this lost wealth.

The cash value that is inside of a permanent life insurance policy may also be accessed tax-free to use for debt payoffs, financing large purchases, or as a supplement to future retirement income (via a LIRP, or life insurance retirement plan).

But in order to make use of these tax-advantaged strategies, it is important to understand how a life-insurance policy should be structured, and what the rules are for keeping these benefits in place. Otherwise, you may end up losing them. 

Life Insurance Can Help Manage Risk

For more than two centuries, people have been using life insurance as a risk-management tool. The obvious needs that life insurance fills include providing liquidity for paying the insured’s funeral and final expenses, as well as being a vehicle for paying survivors’ ongoing living expenses when the insured’s income disappears.

Throughout the years, more advanced life-insurance strategies have been implemented, primarily because this financial tool can provide some significant tax-related advantages. For instance, life insurance death benefits are received income-tax-free to beneficiaries.

In addition, the cash value in permanent life insurance policies allows tax-deferred growth of the funds inside the policy. This means no taxes will be due on any annual gains, and therefore the account can compound its growth over time.

It is important to follow all the rules that pertain to using this coverage in your overall planning, and make sure things are properly structured. Otherwise, it can cause some unpleasant tax-related issues. 

Finding a Strategy that Won’t Backfire

Life insurance can add much more certainty to an overall financial plan, especially given its payout guarantees. But not just any life insurance policy will do the job(s) you want it to do. There are actually many different types of plans available, so choosing the one that best fits your specific needs is crucial.

For example, “term” life insurance will stay in force only for a certain time period, or term. So if you’re in need of coverage for the remainder of your lifetime, a permanent life-insurance policy will likely be the better option.

Even with the right policy in place, though, you could still run into issues that can turn a policy with several tax advantages into a taxable situation. As an example, “overfunding” a permanent life-insurance policy could turn it into a Modified Endowment Contract, or MEC. This is a life insurance plan where the cumulative premiums that have been paid into it during the first seven years are more than the amount necessary to provide a “paid up” policy, based on seven “statutorily defined” level annual premiums.

Why should you be concerned about this?

One reason is because if it is established that a life insurance policy meets the definition of an MEC, it will no longer receive favorable income-tax treatment. This being the case, if cash from an MEC is accessed via a loan or withdrawal—as well as if it is used as collateral for a loan—all of the distributed funds that are considered gain will be taxed as ordinary income. In addition, once a life insurance policy is classified as an MEC, it will continue to remain so, even if you reconfigure later on.

There are other life-insurance tax traps to be mindful of, as well. Falling into one of those traps could mean that even the policy’s death benefit proceeds will be taxable to the beneficiary. For instance, the “Goodman Triangle” can arise when three different people play the roles of the insured, the beneficiary, and the policy owner.

For example, Person A (the owner) owns a life insurance policy on Person B (the insured) and names Person C as the beneficiary, who then receives death-benefit proceeds. Those proceeds can be viewed as a taxable gift from the owner to the beneficiary and can subject the owner to gift taxes on the amount that is over the $15,000 gift-tax exemption in 2020.

Sharing life insurance proceeds with Uncle Sam means that there is less (and in some cases, much less) to use for the survivors’ needs, which could lead to some unintended financial hardships down the road. 

Solving One Dilemma without Causing Another

When it comes to financial and retirement planning, there can be a lot of “moving parts.” Because of that, you could find that solving one financial issue may cause another issue to arise. That’s why it’s so important to look at the whole picture, rather than just separate or individual objectives.

With that in mind, working with an advisor who is experienced in growth, income, and financial-protection strategies is a must. In addition, aligning with a financial professional who has a focus on the LGBTQ community can help ensure that your short- and long-term goals are matched with the right financial tools to get you there.

This material contains only general descriptions and is not a solicitation to sell any insurance product or security, nor is it intended as any financial or tax advice. Guarantees are based on the claims paying ability of the issuing company.


Grace S. Yung

Grace S. Yung, CFP, is a certified financial planner practitioner with experience in helping domestic partners plan their finances since 1994. She is a principal at Midtown Financial LLC in Houston and was recognized as a “Five-Star Wealth Manager” in the September 2017 issue of Texas Monthly.
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