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By: FEDweek StaffWith all types of life insurance policies, the payout at death usually can be received by the beneficiary, free of income tax. Permanent (“cash value”) policies have other tax benefits, too:
* Tax-free buildup. Inside the cash value, any investment earnings won’t be taxed, in most situations.
* Tax-free access. You can tap your cash value by taking loans and withdrawals. As long as you don’t pull too much money from your policy, no tax will be due. Your agent can help you determine how much you can take from the cash value, tax-free, without having the policy lapse.
However, accessing the cash value takes patience. In most permanent life policies, the first-year premium goes largely to the agent, as a sales commission. It can take years for enough cash value to build up so that tax-free loans and withdrawals are practical.
You should plan on waiting at least 15 years (20 is better) before tapping the cash value of your insurance policy. If your time horizon is that long, tax-free loans and withdrawals from a permanent insurance policy can be a valuable supplement to your retirement income.
You don’t have to die to produce cash from your life insurance policy. If you have a cash value policy, you can exchange it for an annuity and not owe any tax. If you select a single-premium annuity, the insurance policy’s cash value can buy the policy and you won’t have to make any further payments.
Suppose, for example, your old life insurance policy has a cash surrender value of $45,000. Exchanging this policy for a single-premium annuity is equivalent to investing $45,000 in an annuity.
You could use this $45,000 worth of cash value to buy a single-premium deferred annuity. If that’s the case, your $45,000 investment can grow, tax-deferred, until you decide to take cash from the annuity.
Another strategy is to exchange for a single-premium immediate annuity. Then your $45,000 will obtain a series of periodic payments.
Once you decide which type of annuity you’d prefer, ask your financial advisor to suggest one with attractive features. The company selling that replacement annuity will help you execute the tax-free exchange.
Bear in mind that some life insurance policies offer an accelerated death benefit rider. This allows the policyholder to receive a portion of the policy’s death benefit if diagnosed with a terminal illness, providing financial support for medical expenses or other needs.
And in some cases a life settlement allows a policyholder to sell the policy to a third party for more than the cash surrender value but less than the death benefit. The buyer continues to pay the premiums and receives the death benefit when the insured passes away. This can provide an immediate source of cash for the policyholder.
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