How to Optimize Your Life Insurance Planning for Taxes


Buying a life insurance policy can help provide additional funds for your beneficiaries if needed and help cover many of their expenses after you are gone. An advantage of using life insurance proceeds is that it is generally not taxable. Making sure it helps your beneficiaries the most requires optimizing your life insurance as part of your retirement planning.

Life Insurance Proceeds Usually Not Taxable

Most of the time, the Internal Revenue Service (IRS) says that life insurance income is not taxable for the beneficiaries of the deceased. You do not need to report it on your taxes.

One exception is when you receive life insurance proceeds in payments, and the account earns interest. In that case, you will pay taxes on the interest earned. If you must report it, you can use either Form 1099-INT or Form 1099-R.

Whole Life Is Better Than Term Life for Retirement Planning

As part of your insurance planning, it is better to buy whole-life insurance, which can go by many names, including permanent life insurance. There are two basic types of life insurance—whole-life or term life—but they have many variations, options, and names.

Although whole-life policies are more expensive for the coverage given when compared to term-life policies, stable premiums can be beneficial for financial planning because you will know what your premiums will always be. These policies also build a cash value that can be used in retirement for long-term health care, medical expenses, nursing homes, or home care, if needed. If you use it for such purposes, it will diminish the face value of the policy.

Term life insurance is not ideal for retirement planning for two reasons. First, you must renew it after each term is completed. Terms typically range from five to 30 years. When it does, the cost goes up based on your age. Second, term policies have no cash value, which gives you nothing in return.

Whole-Life Cash Values Can Give You More Income in Retirement

Buying a whole-life insurance policy when you are younger gives the policy time to build a sizable cash value. You can withdraw it and use it to supplement income from Social Security and other retirement plans.

When you withdraw the cash value from an insurance policy, it is not taxable. It allows you to have extra income tax-free. The one thing you need to be careful of is that withdrawals reduce the face value of the policy.

It can be a real problem if the policy owner dies and is unable to leave much for the surviving spouse and others who may depend on it for income. If you withdraw all of the cash value, it cancels the policy.

Premiums for Life Insurance Policies Not Tax-Deductible

Life insurance premiums are usually not tax-deductible. The one exception is if you own a business and pay for the life insurance of your employees.

Situations Where Taxes Must Be Paid

  • When it is part of the estate:

Anything that goes to the estate is taxable if it is above a certain amount. For 2024, NerdWallet says the federal exemption limit is $13.61 million. When estate values are above that amount, they can be taxed at a rate of up to 40 percent. A few states also have an estate tax—which usually has a much lower threshold than the government—except for Connecticut. Some states have an additional inheritance tax.

  • When there is outstanding debt:

If the insurance proceeds go to the estate, creditors may have access to them to pay off debts. TrustandWill says that all bills must get paid before the assets are distributed. When a living beneficiary is named, the proceeds avoid probate.

  • When there is no beneficiary:

If no beneficiary is named on the policy, or if that person is deceased, the proceeds automatically go into the estate. Even if your will designates a beneficiary for the life insurance policy, it cannot override a beneficiary named in a policy because the policy is separate.

  • When transfer-for-value rules apply:

Congress declared that the practice of avoiding taxes by trading a life insurance policy for money or other value, CRICPA says, negates the tax-exempt status of a life insurance policy. In this situation, the value paid to the policy’s owner, plus the future premiums paid by the new owner, stays untaxable, but proceeds above those amounts are taxable.

  • When the policy is surrendered for its cash value:

Borrowing against the cash value of a life insurance policy may cause tax issues if you borrow more than the cash value, says MassMutual. Borrowing the money is an excellent option for retirement income, but if the policy lapses or you surrender it and have not paid the loan back, you will owe taxes on the money that is more than the cost basis.

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Loans from the cash value are treated like other loans, even though you do not have to pay it back. Interest is charged on that amount and will be subtracted from the proceeds.

How to Escape Taxes When Estate Planning

Avoiding taxes on life insurance proceeds can also be accomplished by making an irrevocable life insurance trust the beneficiary. Because you no longer have control of the assets in this kind of trust, it escapes taxes. Before taking this action, be aware that it also removes the possibility of accessing the cash value.

Optimizing your life insurance for tax purposes can enable you to enjoy more tax-free money in retirement. Consult with a financial planner or an estate planning lawyer to ensure you avoid mistakes.

The Epoch Times copyright © 2024. The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.


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