What Is Permanent Life Insurance?
Permanent life insurance is policies that span your entire life and offer a cash benefit and savings portion. In business succession planning, especially when funding corporate buy-outs, one of the primary considerations should be the tax advantages of permanent life insurance.
The primary reason businesses purchase key man life insurance is to protect the company from unnecessary risks. However, permanent life insurance has other valuable business uses as well including providing valuable executive benefits, funding corporate buyouts or to supplement retirement income for business owners.
Key Takeaways of Permanent Life Insurance Tax Advantages
Permanent life insurance offers a unique mix of tax benefits, including tax-deferred growth of the cash value account and income tax-free life insurance death benefits for beneficiaries.
The cash value life insurance portion can provide a source of liquidity for retirement income or business needs without adding to taxable income, if accessed through withdrawals up to the cost basis and policy loans.
Properly structured life insurance contracts can help businesses fund buy-sell agreements, retain key executives, and keep the company in a lower tax bracket by using distributions in a tax efficient manner.
If a policy is surrendered or lapses, outstanding loans and gains may become taxable, creating potential tax consequences and requiring you to pay taxes on amounts exceeding the policy’s cost basis.
Consulting with a financial professional for tax advice or accounting advice helps ensure you comply with IRS guidelines, maintain the policy’s favorable tax treatment, and avoid losing money through mismanaged withdrawals or loan interest.
Here’s a quick guide to buying life insurance as a tax reduction strategy:
- Tax Deferred Accumulation of Cash Values
- Tax-Free Income Using Withdrawals and Loans
- Income Tax-Free Proceeds to Policy Beneficiaries at Death
How Taxation of Permanent Life Insurance Works
Benefits of Permanent Life Insurance
Permanent Life Insurance has a unique combination of tax advantages which are not available with any other financial, investment, or cash accumulation product¹.
These advantages include:
- tax deferred cash values
- tax-free income via withdrawals
- loans and income tax-free death benefits
One of the chief tax advantages of permanent life insurance is the tax deferred growth of cash values.
With business life insurance, policy cash values can be listed as assets on the company balance sheet and can be accessed for use by the company at any time. The tax deferral of cash growth makes key man life insurance an ideal vehicle for funding executive compensation plans, creating supplemental retirement income for business owners, or to fund a corporate stock redemption plan.
Tax deferred growth is also available with other financial and investment products such as annuities and qualified retirement accounts. However, life insurance is the only cash accumulation product which offers the combination of tax deferred growth of cash values and the ability to structure cash distributions which may be received tax free.
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Taxation of Whole or Universal Life Insurance
Another tax advantage found in whole life or universal life insurance policies is the cash value may be accessed by the company tax free. If structured properly, policy withdrawals and loans can be used to essentially eliminate taxes on cash received from a life insurance policy.
Withdrawal of cash value from a life insurance policy is generally not taxable as long as the amount withdrawn does not exceed the policy premiums which have been paid, commonly referred to as the “basis”. Once the policy’s basis has been withdrawn, future withdrawals are subject to income taxation.
To avoid taxation on life insurance distributions in excess of the policy’s basis, loans can be used to access additional cash values tax free. You also need to be careful any tax deductions you attempt to take, as it can impact the taxation of the life insurance policy benefits.
As long as the insurance policy meets certain IRS guidelines, policy loans are not taxable. There is no income tax on the amount borrowed, but loan interest will be charged by the insurance company on any outstanding loan balance. Policy loans do not have to be repaid.
However, if an outstanding loan is not repaid before the insured’s death, the policy loan balance including any unpaid interest will be deducted from the policy’s death benefit.
Even though policy loans are not taxed, there are certain conditions when taxes on loans may apply. When a life insurance policy is surrendered, any amount of cash values actually received in excess of the policy’s basis will be subject to income taxation. Existing policy loans are then considered cash distributions and included in the calculation of the policy basis.
When a policy lapses, any outstanding loans are treated as cash value distributions and subject to taxation on any amount in excess of the policy basis.
Taxation of Death Benefits for Business-Owned Life Insurance
Under IRC section 101 (a)(l), business-owned life insurance policy death benefits payable to the company may be received income tax free as long a certain conditions are met.
These conditions, for both the state and federal level, may include, but not be limited to:
- the covered employee or executive providing written consent to be insured;
- signing an acknowledgement and them falling within a certain employee classification or group.
Frequently Asked Questions (FAQs) About Permanent Life Insurance Tax Advantages
Are life insurance premiums tax deductible?
Generally, premiums for permanent life insurance policies are not tax deductible for individuals. However, in certain business settings, such as when a company owns a policy for a key employee, the premiums may be deductible if structured as part of a tax deductible executive bonus plan. A tax advisor or certified financial planner can help determine if your business qualifies.
Do beneficiaries owe taxes on a life insurance payout?
Most life insurance death benefits are generally paid to beneficiaries on an income tax-free basis, which makes them a valuable tool for estate planning and providing financial security. However, if the policy is owned by a business or part of a taxable estate, there could be estate taxes to consider.
How does cash value in a life policy grow?
The cash value component of a whole life insurance policy or universal life policy grows on a tax deferred basis, meaning you won’t owe income taxes on the growth as long as it stays inside the policy. This makes it a tax efficient way to accumulate wealth compared to other investment options that generate taxable income annually.
Will I owe taxes if I withdraw from my cash value account?
Withdrawals up to the cost basis (the amount of premiums you’ve paid) are usually not taxable. If you take out more than your cost basis, that excess may be included in gross income and subject to taxes. Many policyholders choose to access funds through policy loans to avoid triggering immediate tax consequences, but unpaid loans will reduce the death benefit.
Conclusion and Summary of Why Buy Permanent Life Insurance
Whole life insurance has a unique combination of tax advantages including tax deferred growth of cash values, tax free income via withdrawals and policy loans, and tax free death benefits.
This combination of attributes is not found in any other cash accumulation product. The special tax advantages of permanent life insurance make it a an extremely attractive solution for cash growth, supplement retirement income or retaining key employees with executive bonus plans. To learn more about permanent life insurance costs or to get a quote for key man insurance contact us today.
(1) All of the above tax information is for information purposes only and is provided to explain the basic tax treatment of life insurance based on the Internal Revenue Code. Any individual or entity considering any life insurance policy should consult with their own CPA or tax/legal advisor that understands their particular tax circumstances and the rules governing their state. In no way is this information intended to be tax or legal advice.
