Tax time is almost here. If you’re like millions of Americans, you’ve already filed your return. Perhaps you got a nice refund. However, it’s also possible that you owed taxes, maybe even more than you’d anticipated.
If you’re in sticker shock over how much you paid in taxes last year, now is a good time to review your financial strategy, especially with regard to taxes. If you’re approaching retirement, it’s even more important to develop and implement a tax strategy. Taxes are one of the biggest expenses you may face in retirement. Without a plan in place, taxes could reduce your income and diminish your ability to fund your lifestyle.
Fortunately, there are tools you can implement to reduce your taxes both today and in retirement. One of the most effective is life insurance. Yes, life insurance is primarily a protection tool for your loved ones after you pass away. However, it can also be used to achieve other financial goals, including tax-efficient growth and retirement income. Below are a few ways you could use life insurance to reduce your tax bill:
If you have an IRA or 401(k), you’re probably familiar with tax deferral. In these types of qualified accounts, your assets have growth potential. However, you don’t pay taxes on growth as long as the funds stay inside the account. All taxes are deferred until you take withdrawals at a later date.
Tax deferral is a valuable retirement savings tool. If you’re not paying taxes on growth each year, your assets can compound over time. In fact, they may grow at a faster rate than they would in a taxable counterpart.
Permanent life insurance policies have a cash value account. When you pay a premium, a portion goes toward the cost of the insurance, and the remainder goes into the cash value account. Your cash value can grow over time, depending on the terms of the policy.
For example, whole life policies pay annual dividends. In a universal life policy, you’ll likely receive annual interest. Variable universal life policies allow you to strategize in financial markets, so you have growth potential but also risk exposure. There are also fixed indexed universal life policies that offer downside protection and interest rates based on the performance of financial indexes such as the S&P 500. Your choice of policy should be based on your specific needs and goals.
No matter which type of policy you choose, one thing is the same: Growth inside the policy is tax-deferred. That means you can use your life insurance policy as an additional source of tax-deferred growth above and beyond what you get via your other qualified accounts. That could be especially helpful if you’re already maximizing your contributions to your 401(k) and IRA.
In a 401(k) and a traditional IRA, your growth is tax-deferred, but that doesn’t mean it’s tax-free. Your distributions from these accounts are taxed as income. That means you may achieve tax-efficient growth, but you could also be creating a future tax liability in retirement.
Life insurance offers a couple of ways to take tax-free distributions from your policy. One is through a withdrawal. Life insurance policies follow a “first in, first out”—or FIFO—tax structure. The first dollars that go into your policy are your premiums, which are usually made with after-tax dollars. When you take a withdrawal, your premiums are the first dollars to come out. Since you’ve already paid taxes on those dollars, the withdrawal is tax-free.
Once you withdraw all your premiums and start withdrawing growth, your distributions could be taxable. However, you can work with a financial professional to carefully schedule and plan your distributions over time so you don’t deplete your tax-free premium distributions.
You can also take a loan from your life insurance policy. All loan distributions are tax-free. The catch is that you have to repay the distributed amount. The repayments are usually made as an add-on to premium payments.
If you surrender the policy before repaying the loan, the outstanding balance could become a taxable distribution. If you pass away and haven’t repaid the loan, the balance may be deducted from the death benefit.
You may not be able to use life insurance distributions to fund your entire retirement. You could, however, use life insurance as a source of supplemental tax-efficient income. That could help you reduce the amount you need to withdraw from taxable sources like your 401(k) or IRA, which in turn could reduce your overall tax exposure.
Ready to take control of your tax strategy? Let’s talk about it. Contact us today at Thomas Financial. We can help you analyze your needs and develop a plan. Let’s connect soon and start the conversation.
Licensed Insurance Professional. This information is designed to provide a general overview with regard to the subject matter covered and is not state specific. The authors, publisher and host are not providing legal, accounting or specific advice for your situation. By providing your information, you give consent to be contacted about the possible sale of an insurance or annuity product. This information has been provided by a Licensed Insurance Professional and does not necessarily represent the views of the presenting insurance professional. The statements and opinions expressed are those of the author and are subject to change at any time. All information is believed to be from reliable sources; however, presenting insurance professional makes no representation as to its completeness or accuracy. This material has been prepared for informational and educational purposes only. It is not intended to provide, and should not be relied upon for, accounting, legal, tax or investment advice. This information has been provided by a Licensed Insurance Professional and is not sponsored or endorsed by the Social Security Administration or any government agency.
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