Life insurance provides tangible and intangible benefits. A major intangible benefit is the peace of mind you get by securing the financial future of your loved ones. Tangible benefits depend on the type of insurance. Permanent life insurance provides tangible benefits that include cash value and life insurance tax benefits.
Identification
Permanent life insurance is long-term insurance that does not expire unless you fail to make premium payments or cancel the policy. This is in contrast to short-term insurance, or term, insurance that has a set beginning and ending date. Main types of permanent life insurance include whole, universal and variable universal life insurance. Each of these types combines a death benefit with a savings potion that accumulates cash value. Life insurance tax benefits are greater with permanent life insurance plans.
Types
A tax benefit that applies to permanent and term insurance is the nontaxable death benefit. Your beneficiaries will not have to pay income tax on any portion of the money they receive. Permanent life insurance also provides additional tax benefits. First, the cash value portion of the policy is not subject to income tax as it accumulates. If you make no cash withdrawals, you pay no tax. Second, if you take out a loan against the cash value of the permanent life insurance policy, you are not responsible for paying income tax on the loan amount. This is because the Internal Revenue Service views life insurance loans as debt rather than income.
Requirements
For a life insurance policy to be eligible for tax advantages, it must pass one of two eligibility tests, according to Internal Revenue Code 7702 (c) and 7702 (d). The first is the cash value accumulation test and the second is the guideline premium and corridor test.
The cash value accumulation test says the current cash value of the policy cannot be more than what a single premium payment would cost to purchase the same policy. For example, if a life insurance policy has a current cash value of $20,000, the cost to purchase another policy of the same type, making only one payment, must be at least $20,000.
The second test is actually a combination test. The guideline premium test says the total amount of paid-in premiums cannot be more than what a single premium payment would be to purchase the same policy or total premium payments cannot be more than the face value of the life insurance policy, whichever is more. The corridor part of the test says the cash value of the policy cannot be more than a percentage of the death benefit value. This percentage depends on a person's age and declines each year until the age of 95. This test is in place to limit the amount of money you can invest in a single life insurance policy.
Advantages
Life insurance tax benefits can aid in retirement and tax planning. While there are strict annual limits on the amounts you can contribute to retirement plans like a 401k and Individual Retirement Account, there are no such restrictions when it comes to life insurance. When you want to use this money, taking out a loan against the policy, versus making a cash withdrawal gives you tax-free access to funds. In the meantime, you created a tax shelter to protect financial assets.
Considerations
Permanent life insurance premiums depend on factors like your age, health, whether or not you smoke and family health history. As a result, permanent life insurance can be costly. Life insurance is not a short-term investment tool. If you cancel or make cash withdrawals from a permanent life insurance policy, you lose all tax benefits and become liable for paying income tax on the cash value of the policy.
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