The tax consequences of whole life insurance
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Deciding whether or not to buy a life insurance policy usually comes down to choosing permanent policies such as whole life insurance or the shorter term option of term life insurance. Choosing between the two requires careful consideration of the pros and cons, including the tax implications of both regimes.
We asked Jarrett Topel, financial advisor and member of NerdWallet’s Ask an Advisor network, to describe some of the key tax pros and cons of whole life insurance policies and offer tips for consumers on making the right decision.
What Are the Lifetime Tax Benefits?
The first big tax advantage of whole life insurance is the tax-free death benefit – the money you put into the policy is distributed to your beneficiaries upon your death, tax-free (as is the case with term life insurance, if the contract holder dies during the period covered). Plus, if managed properly, whole life insurance policies can provide tax-free loans to the homeowner. These loans come directly from the death benefit that would go to your beneficiaries and do not need to be repaid (again, assuming the policy is managed properly). These loans can be a source of cash that can be used for a variety of reasons, such as funding college or additional retirement income.
What are the potential pitfalls?
A potential pitfall with whole life insurance policies and their associated tax-free loans is that, if not managed properly, the policy loan can become taxable, often exactly when the client can. less afford it. This can happen if the policy expires or is surrendered. Also, keep in mind that if the policy loan plus the accrued interest on that loan exceeds the actual cash surrender value available in the policy, you may need to put more money into the policy or the policy may be required. be terminated by insurance. company, potentially creating a taxable event.
For example, let’s say the policy has a cash value of $ 10,000 and the owner takes a policy loan of $ 9,000. If the interest on this loan is also paid from the cash value (which is now only $ 1,000 due to the $ 9,000 loan), then once you have accumulated more than $ 1,000 d Interest accrued, the total of your original loan ($ 9,000) plus interest paid or payable ($ 1,000 and over) will be greater than the original cash value of $ 10,000 available.
In this situation, you will either have to fund the policy with more money or let it expire, in which case the loan becomes taxable. The lesson to be learned is that policyholders need to be careful about how and when they access the cash value of their policies.
Another potential pitfall with whole life insurance policies is that they are usually more expensive than buying term insurance, which covers a number of years. If someone takes out a whole life insurance policy and can no longer afford to continue paying premiums due to an unforeseen financial or health event (for example, a layoff or work stoppage), the consumer often ends up letting the policy expire. In this scenario, the consumer was never able to take advantage of the tax-free cash value portion of the policy and paid more for insurance coverage that would have been cheaper with term insurance.
How do these factors affect other parts of retirement planning?
While the tax advantages of using whole life insurance can be attractive, you should weigh this advantage against the potentially lower overall returns you could receive if you use your whole life insurance policy as an investment vehicle for the life. retirement. The cash value (investment side) of whole life insurance policies often earns interest in the range of 1% to 3% per annum. So the question becomes: can you meet your retirement goals with an interest rate of 1% to 3%? The answer to this question, for most people, is a categorical no.
As such, the guaranteed return may “feel” good for the average investor, but in reality it can only guarantee that he can never afford to retire. This is why we so often recommend that clients purchase term insurance and invest the difference (the savings from lower insurance costs) in a diversified portfolio of mutual funds and / or negotiated funds. in stock exchange.