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Wealth Planning News

Vol. IV, No. 10

Favorable Tax Treatment of

Life Insurance

Something that may influence your decision to buy instead of rent life insurance are the favorable tax breaks given to owned life insurance.

Remember there are two basic types of life insurance: The kind you rent (what you might call term) and the kind you buy (permanent insurance of one type or another).

Newsletter 4.9 discussed these two types of life insurance, and compared renting insurance coverage to renting a house, and buying insurance coverage to buying a house. Here we expand on that comparison by mentioning some tax benefits of insurance ownership. Homebuyers and life insurance buyers (but not renters) get some very favorable tax benefits.

Newsletters 4.11 and 4.12 deal with the question of why to acquire life insurance coverage.

Benefits to Insurance Owners

Tax Free Growth


The law gives a special income tax benefit to you when you buy (but not if you rent) life insurance. Income on the investment portion of your life insurance policy is not taxed. So the investment part of the policy can grow in value at a rate that is compounded without any income taxes.




No Tax on Withdrawals

You may take out part of the equity or investment account without paying income taxes on what you take, until after you use up all the funds you had put into the policy. And you may borrow funds from a policy to avoid taxes on growth. As with profits on a home, there are limits here. The policy must remain in effect until you die (and with a universal policy you can reduce the death benefit later to make sure it remains in effect without any further premium payments) or you will have to pay taxes on the investment growth inside the life insurance policy.

No Income Tax on Death Proceeds


In the case of life insurance the proceeds pass to your loved ones and they don’t have to pay income tax on the proceeds. (The few exceptions are not worth mentioning for the typical family).


Death Tax Benefit


There is a way to keep your loved ones from having to pay estate taxes on life insurance proceeds when you die. Don’t personally own the policy! Instead, use the annual gift tax exclusion of $14,000 per year (indexed for inflation) to avoid taxes on gifts of the premiums you make to a gifting trust set up to own the life insurance. If the trust is properly designed the insurance investment part of the policy can even be available indirectly during life if you need it, while keeping the policy proceeds entirely free from any taxes.

Benefits to Home Owners

Mortgage Interest Deduction


You have a special tax break given by law if you buy a home. Interest paid on your mortgage is deductible against your income. The government in effect subsidizes home ownership, as opposed to home rental. The effect has been to encourage large home mortgages, which allow buyers to get larger homes. You can even deduct the mortgage interest on two residences, your principal residence and a second residence.

Tax Benefits on Sale


You can sell your home and avoid paying any capital gains tax on the growth in its value. If the house cost $100,000 and over time it grew to be worth $350,000, you can sell and not pay any tax on the $250,000 of profit. There are limits of $250,000 of profit, per person, on sale of a principal residence. If you are married, you and your spouse can shelter $500,000, of profit from taxes. So proceeds can come out tax free in many cases.

Step-up in Basis at Death


In the case of a house, your loved ones get what is called a step up in basis equal to value at date of death. When your loved ones sell the house they pay no income tax on the difference between its value when you died and the amount you paid for it.

Death Tax Benefit


You can put a house into a special Qualified Personal Residence Trust (QPRT), reserve the right to use it for a term of years, and after the term of years the house and all growth in its value have been removed from your taxed estate. The gift was made when you created the QPRT. The value of the gift was the value of the house, reduced by your right to use it for the term of years. So the value of the gift can be incredibly small.

We help you review the issue of when to rent or buy insurance, and if you buy we help design the type of insurance to buy.

Call us for a consultation if you want more information on this topic. 

Copyright 2022 Hopp & Associates, PC

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