What is whole life insurance?
In simple terms, life insurance provides a payment of money to your loved ones if you pass away. While there are multiple types of life insurance, whole life is a form of permanent life insurance that comes with many features. Whole life insurance benefits you for your entire life, as long as you keep your payments up to date. It also has a cash value component that is money you can use during your lifetime.
What’s the benefit of cash value?
The cash value piece of your whole life insurance will increase each year1 on a schedule guaranteed by the insurance company,2 allowing it to grow throughout your life. It’s also likely to grow from annual dividend payments (payments the insurance company shares with policyholders from their profits), if you buy the policy from a mutual whole life insurance company.3 As long as you pay the premium (the amount you owe for the insurance) your coverage can’t be cancelled for any reason. This could be a big plus when you’re older. Even if you live a very long life, your beneficiaries will receive a guaranteed sum of money after you’re gone.
Apart from the certainty that your loved ones will receive an income-tax-free sum of money (referred to as a death benefit in the policy), there are other benefits you get from a whole life insurance policy, including tax considerations.4
The cash value of your whole life insurance policy will not be taxed while it’s growing. This is known as “tax deferred,” and it means that your money grows faster because it’s not being reduced by taxes each year. This means the interest you make on your cash value is applied to a higher amount.
It’s also likely that your earning power during your prime working years will put you into a higher income bracket, meaning you’re paying a higher percentage of your income to taxes. Later in life, when you’re no longer bringing home a regular paycheck, your income and your tax bracket could be lower.So if you withdraw your money when you’re in a lower tax bracket, it will get taxed less than when it was first applied to your account.
Along the way, if you want to access the cash value that has accumulated in your policy, you can take out loans or withdraw the money without tax consequences (as long as they’re structured properly).5 Makesure you work with your insurance representative to help you avoid unnecessary taxation. There are many reasons you may want to borrow or take out cash — a loan without needing bank approval, college fees for a child, a property down payment, cash to use in retirement, or for any other reason. Some people use their cash value to pay their insurance premiums, or even to purchase more insurance with a higher death benefit to leave loved ones a bigger amount of money.
Dividends from the insurance company
Whole life insurance is a robust, permanent type of insurance that doesn’t simply vanish once a time frame is over — unlike the basic term life insurance that many people buy — and your cash value can help create a significant asset. Interest and dividend payments from the insurance company can build up your cash value (annual dividends are never guaranteed, but some mutual life insurance companies pay them out year after year). Another factor is taxes. In general, the "interest build-up" portion of the annual increase in the policy's cash value is not taxed annually by the IRS.6
Dividends — those payments the insurance company may make to your account depending on their profits that year — are also generally not taxable. This depends on which stage the cash value has reached, an aspect of the policy that should be talked about with your financial representative and a tax advisor as it can get complicated.
Another feature of life insurance is that the money your beneficiaries receive after you’re gone isn’t subject to income taxes, although they may be subject to federal estate taxation.7 State inheritance taxes and federal gift taxes may also apply to life insurance policies and proceeds under specific circumstances. Consult your tax advisor with questions about income, estate, and gift tax consequences.
Take a loan or withdrawal without paying tax
Another life insurance tax benefit kicks in if you decide to borrow against your cash value. Although this type of loan isn’t treated as taxable income, it will have interest charged by the insurance company until you pay it back, and each insurance company has its own rates. You can also choose not to pay the loan money back, although this would affect the amount of your life insurance payout to your beneficiaries. There are several approaches to consider when deciding whether to withdraw or borrow from your cash value. It’s important to talk to your financial representative to decide which choice is best for you. Whole life policies have responsibilities and costs, but they offer a high level of predictability and reliability in terms of the guaranteed sum your beneficiaries receive. Make sure to choose a reliable company with a long track record of financial stability.8
Leave more to your heirs
The third major life insurance tax benefit affects the money your beneficiaries will receive after you pass away. This is normally untaxed and is generally quicker for them to receive than things like property and other physical assets.9 While an estate has to go through “probate” processes (even if you leave a will) that can take several months, under most circumstances, the life insurance payout will get to your beneficiaries within weeks. The death benefit itself is normally income-tax-free.
As an additional example of the benefits that come with a whole life insurance policy, there are ways to use the policy to reduce tax obligations on other income. For instance, if you wish to give a gift to your favorite non-profits and charities, you could reduce your income tax in a given year by signing over some of the benefits of your whole life insurance policy and naming the charity as a beneficiary. Talk to your tax advisor to find out more about reducing your income by giving your cause a lasting gift.
Whole life insurance policies offer permanent lifetime coverage and a guaranteed way to leave money to your loved ones. As an added benefit, this type of policy grows a stable, tax-favored cash value that you can use during your own life. There are many advantages of owning a whole life insurance policy, but tax regulations can be complicated. Discuss your plans with a financial representative and a tax advisor who can help you decide which type of protection will do the most for you.