The US government has long encouraged the purchase of life insurance to provide for widows and orphans. Life insurance therefore receives a favorable tax treatment. Premiums are not deductible, but the death benefit is tax free, as is the buildup of cash value within the policy, in most cases. Because of this tax treatment, life insurance can be an attractive investment or savings alternative, especially for those in higher tax brackets, or who have maximized their available contributions to Roth IRA accounts and other tax-advantaged retirement plans.
1. Identify the nature of the life insurance policy. If the policy is a participating policy from a mutual life insurance company, it will be eligible for non-guaranteed dividends. Otherwise, it will simply receive the guaranteed crediting interest rate, or the investment returns of underlying subaccounts, in the case of variable life insurance policies. Dividends receive somewhat different tax treatment than interest or investment returns in subaccounts. Distributions of dividends are considered a return of premium overpayment, and are tax free.
2. Print an illustration, or get your insurance agent to do this for you. An illustration is a projection of policy cash values, death benefits and premiums, given a set of assumptions. You can generally define the set of assumptions and customize the illustration. Your insurance agent can generate a projection of the internal rate of return on the policy out to age 120, in most cases. However, dividends are not guaranteed, nor are any investment returns in variable accounts. The same, however, is true of most comparable taxable investment alternatives.
3. Calculate the taxable equivalent yield of the insurance policy at various points in your life expectancy. You can do this by applying the following formula: taxable equivalent yield = life insurance policy returns / (1 - your marginal income tax bracket). The result is the expected yield an alternative taxable investment must generate to beat the return in the tax-advantaged life insurance policy. This is the same calculation used to compare the yields of municipal bonds against taxable bonds.
- Don't lose sight of the ultimate reason for the life insurance policy: The life insurance policy exists to provide a tax-free death benefit to the insured's survivors.
- You can withdraw dividends from a life insurance policy tax free. However, once you have withdrawn all your dividends, the most tax efficient way to tap your cash value is through a loan against the policy. You don't have to pay the loan back, the loan will accumulate interest and the insurance company will pay itself back out of the eventual death benefit. However, consider carefully how a reduced death benefit will affect your survivors, if you withdraw or borrow against the policy.
- Also, take into account the insurance benefits of the life insurance policy, such as an accidental death benefit rider, or a rider that pays premiums for you -- resulting in cash value accumulation -- if you become disabled and can't work anymore. This may be a valuable element in your overall portfolio.
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