With April 15 only weeks away, too many Americans are positioned to hand over a large chunk of their earnings to Uncle Sam. The current tax code is as complex as ever, and it highlights the importance of exploring all options in order to protect your household income. One of the most overlooked tax saving strategies comes from utilizing life insurance. While many only think of the death benefit component of life insurance, if utilized properly, it creates a savvy tax strategy that fits perfectly into many financial plans.
Before exploring the tax advantages of life insurance, it is important to understand the various tax categories of popular savings vehicles.
Taxed now. Money allocated to these accounts are not taxed later. Interest earned and capital gains are subject to tax. These include CDs, money market and brokerage accounts.
Tax later. Assets are contributed to these accounts pre-tax, and the principle along with interest is only taxed when money is taken out of the account. These include 401(k)s, IRAs and certain other retirement plans.
Taxed never. These savings vehicles are either not taxed or taxed up front, with no additional taxes on interest, gains or certain withdrawals. These include Roth IRAs, 529 plans and life insurance.
With a basic understanding of the various tax categories and where each savings vehicle falls, let’s now shift the focus specifically to life insurance.
For wealthy Americans, I consider life insurance as an essential component of a tax diversified portfolio. Many high-income earners do not qualify for a traditional IRA or a Roth IRA, so their tax saving options are limited from the start. When you consider their additional tax exposures, such as capital gains, life insurance stands out as an ideal vehicle to limit such exposures.
Last year I began working with a doctor who was earning over $300K a year (on paper). After getting walloped by taxes, he was only keeping about half of those earnings. Keep in mind that this is a person who racked up colossal debt and countless hours of intense schooling to get through medical school, now works 80 hours a week and yet he’s only left with a proportionately small portion of his earnings. The situation just wasn’t right, so we made alleviating his tax burden a top priority. As a result, one of the first things we did was introduce life insurance into his financial plan. That action protected his earnings significantly by reducing his tax exposure.
One common misconception is that this strategy only works for the rich, but life insurance can be an excellent tool for the middle class as well. One of the reasons it’s underutilized on Main Street is that many of these families and individuals have less access to reliable financial planning information. They think about it strictly as a tool for protecting loved ones if something were to happen to them, not realizing its tax advantages as a savings tool.
Another reason is that it can be uncomfortable to consider and discuss our own mortality, so these options are dismissed before receiving proper consideration.
The taxes on life insurance are very low – ranging from about half a percent to one percent. There is also a wide range of life insurance products to choose from. There are common term and whole life options. There are also tax value life insurance policies that fit well into this strategy. With these, it is like there is a mutual fund within the life insurance policy. The growth is not taxed, and there’s no limit on how much you contribute (unlike 401(k)s, Roth IRAs, or traditional IRAs where contributions are limited).
Lastly there’s the inheritance component. Life insurance gives you firm method of determining where the payout will go if something were to happen to you. It doesn’t go to probate, as could be the case for retirement funds that aren’t accounted for in your will. Instead, you have complete control over where this portion of your legacy goes.
As you can see, a tax planning and diversification strategy including life insurance can provide a unique set of advantages along with versatility. The taxman is unforgiving to those who are underprepared, so make sure you consult with your adviser to see if life insurance can help you keep more of what you earn.
Mark Tan is a Chicago-based financial advisor with Thrivent Financial, a financial services organization that helps Christians be wise with money and live generously. Learn more about Mark at www.mark-tan.com.
This article by Mark Tan first appeared on Mark Tan and was distributed by the Personal Finance Syndication Network.
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