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When you read or hear the words tax shelter it probably doesn’t conjure images of using whole life insurance. But whether or not whole life is actually a tax shelter depends on how you define it more than anything.
It’s not a tax shelter in any sort of the more shady ways that people discuss tax shelters. But it certainly does fit alongside something similar to a TSA (tax-sheltered annuity) in a more general sense.
If you spend more than a few minutes cruising around ye olde world wide web, you can find all sorts of interesting “information” about various tax shelters. Since this site focuses on the use of life insurance, in particular, a great deal of time and words are written about whole life insurance, I’ll take a look at how whole life works as a tax shelter.
Are whole life premiums tax-deductible?
The first thing to address is the elephant in the room. One of the most common questions I have received over the last two-plus decades of being a life insurance broker is some flavor of “are my premiums for this whole policy tax-deductible?”.
The short answer is no, they are not tax-deductible. Your whole life insurance premiums are paid with after-tax dollars. To many people, particularly those that own a business, this is a disappointing answer. I understand, I own a business, several actually, and paying my life insurance premiums as a tax-deductible expense is appealing for sure. Being able to reduce taxable income by deducting reasonable and customary expenses from gross income is one of the great advantages of being a business owner.
But the IRS has decided and clearly written in many rulings and as part of the IRC that life insurance premiums do not fit the bill as reasonable or customary expenses in the course of running a business.
The one exception to this rule is that a whole life insurance policy can be a part of a qualified plan. That means that technically speaking your whole life insurance policy premium, in this scenario, could be paid with pre-tax dollars. How and why someone would do this is a long and complicated discussion. Typically when this is done, it is done as part of a defined benefit pension plan.
And while yes, there could be potential tax-savings, these plans are quite complex and costly to set up and administer (think more than $20k to start and more than $10k per year to administer). Not to say they are not a good idea, just that most businesses will struggle to justify the expense of setting up a plan like this, though they certainly exist and can work well for the right situation.
Long term tax deferral and the power of policy loans
The real-world application of whole life insurance as an effective tax shelter for 99% of the population is to fund the policy with after-tax dollars. Just pay the tax, set up your policy to receive a budget-friendly (but stretch a bit) premium amount each year, and watch it compound.
Of course, I am assuming that you are purchasing a policy from a company that issues participating whole life insurance that has a long history of paying policyholder dividends. Most good policies are issued by companies that have been doing and doing it well for over one hundred years.
And that your policy is designed correctly to maximize the cash value compounding over the coming decades. That typically means that you are working with a competent life insurance broker.
I like to believe we fit that description, our clients tell us so. If you’d like to talk with us, please go here to our contact form and shoot us a message. We work with clients all over the country.
The best returns from a great whole life insurance policy come from compounding the cash value over time. Yes, of course, you can access your cash value almost immediately if you want to but that’s not our recommendation. In our experience, the best results our clients get is from funding the policy and forgetting about it for a while. It takes a little time to properly capitalize your policy in a way that it can produce self-sustaining momentum for you later in life when you want a tax-free income.
I have mentioned it before, but several years ago I met a guy whose father was an old life insurance broker. His father had the foresight decades ago to stuff as much money as he could into whole life insurance.
Remember this was long before anyone was talking publicly about banking strategies or using whole life insurance as a retirement income tool. Heck, he started this before the internet even existed. And now today, he receives more than $200k per year from his policies and it’s all tax-free.
All the cash value he accumulated over that time has grown without paying any taxes on that growth. And now through the prudent use of policy loans, he is able to have a substantial retirement income without it being taxable. If that’s the first time you’ve ever heard of it, I understand that it seems a little too good to be true but it is real and people do it all the time.
Because you are technically borrowing the money through a policy loan, the life insurance company is loaning you the money. They are using your accumulated cash value as collateral for that loan.
How you get your cash out of your whole policy tax-free
The good news is that life insurance companies make it easy for you to get your money from your policy on a tax-free basis. To give you a little context here, I am talking specifically about the ability to receive a retirement income from your policy on a systematic basis, every year.
Most people who fund their whole life insurance with an eye toward generating retirement income will use a strategy that maximizes sustainable income. Generally speaking, this is done by making use of what we call “withdrawal to the basis, then taking policy loans”
In this strategy, you would first remove cash from your policy all the way up to your total cost basis. If you paid $250,000 in total premiums since you started the policy, you would withdraw cash up to that number and then you would switch over to policy loans.
However, you do not have to do it this way. You can also skip the withdrawal to cost basis and rely solely on policy loans. Which option is better will depend on your circumstances and the loan provisions of your particular policy including the prevailing loan interest rate and current policy dividends.
And of course, outside of having a systematic income withdrawal plan for your policy, you can take policy loans any time that you choose as long as there is cash value in the policy.
Many times those who plan to use their policy for retirement income take policy loans and pay them back several times throughout the years leading to retirement. Our clients have and continue to do so, mostly to pursue other investment or business opportunities. After all the policy cash value is your money, you can use it whatever way you see fit and at whatever time you choose.
Whole life tax shelter summary
While whole life is generally not used as a tool to shelter income from taxes, it is an effective tool to shelter money that has already been taxed from future taxes. The analogy has been made that it is better to pay tax on your seed, rather than your harvest.
It is a good idea to pay the tax now (when rates are probably as low as they’ll be in our lifetime) and shelter all of your cash value as you approach retirement (when tax rates are an unknown) from whatever the prevailing tax rates are at the time. Those factors make whole life insurance an effective tax shelter.
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