Tax Planning with Life Insurance 3 Tax-Efficient Strategies


At Emparion, we are big fans of tax-efficient strategies. But as a general rule, we are not big fans of life insurance. 

However, life insurance can make a lot of sense from a tax planning perspective in the right situation. This post will look at three specific examples where life insurance can be a home run from a tax strategy standpoint. Let’s get going.

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Irrevocable Life Insurance Trust (ILIT)

It can make a lot of sense to transfer an existing life insurance policy into a trust or have a trust established to purchase a new insurance policy. This can be an excellent strategy for estate tax purposes.

Upon your death, your beneficiaries will receive a death benefit that generally is not taxable. However, it is still included in your estate. 

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When the trust owns the policy and makes the insurance payments, the life insurance proceeds are excluded from your estate. As such, they are not factored into your estate for estate tax purposes.

This is a great option when your assets exceed the applicable estate tax exclusion at the time of your death. It can also work well if your goal is to control the money’s timing of receipt of the funds to your beneficiaries.

So even though it is tax-free to your beneficiaries, you may have to pay estate tax on it. 

If you want to minimize estate taxes, you should consider an irrevocable life insurance trust (often called an “ILIT”). An ILIT is a particular type of trust that is irrevocable and cannot be modified. It is meant to hold just one key asset: your life insurance policy.

Another significant advantage is that if your beneficiaries receive “Crummey powers,” any lifetime transfers of funds into the trust used to acquire the life insurance will typically qualify for the annual gift tax exclusion. 

As you can see, this type of policy offers tax-free saving, estate tax exclusion, the accrual of cash value over time. It can indeed be a win-win. Take a look at the chart below: 

Insurance Inside a Cash Balance Plan

You probably know by now that cash balance plans are our favorite retirement strategy. But many people don’t realize that certain qualified retirement plans can be funded (at least in part) by life insurance. They can use plan assets and retirement contributions to pay for the premium payments. 

With this strategy, the plan can purchase life insurance on plan participants with tax-deductible funds. These types of plans can be great in the following situations:

  • Business owners who want life insurance but are also looking for a tax deduction; 
  • Individuals who want to “front load” retirement contributions with large tax-deductible insurance costs;
  • Individuals who may not have the best health rating and want the tax deduction to offset the increased insurance premium costs;

Traditional cash balance plans and defined benefit plans don’t have significant restrictions on the type of insurance policies included in the plan. As a result, variable or universal life policies can be an option. 

defined benefit plan rules

But there are a couple of rules and limitations that need to be considered. The “50 percent test” limits the life insurance portion of the plan to no more than 50 percent of contributions. The other 50 percent can be invested in mutual funds, stocks, bonds, or even a fixed annuity.

If you are looking for large tax-deductible retirement contributions along with some life insurance, consider a life insurance cash balance plan. It makes a lot of sense in the right situation.

Supplemental Executive Retirement Plan (SERP)

A SERP is a type of deferred compensation structure. It is a non-qualified plan, which means it falls outside of IRS qualified plans, such as 401(k) plans, defined benefit plans, and cash balance plans. 

The “deferred” plan structure is due to the agreement to provide a specified benefit at a date in the future. It is often used to supplement and boost other qualified retirement structures.

Plans have custom features, but many are referred to as defined-benefit SERPs. These plans are structured to provide a percent of an employee’s compensation or a flat dollar amount at retirement. 

Many business owners will buy a life insurance policy. This provides funding certainty and limit’s the employee exposure. 

Non-Qualified Deferred Compensation Plan

Even if you have a retirement plan in place (like a 401k, cash balance plan, or defined benefit plan), you might find that your retirement account balance might be less than you would like. A non-qualified deferred compensation plan (often called a “NQDC”) may be a good option.

There is a lot of flexibility in the funding mechanism on these types of plans. But let’s assume it is funded through a corporate-owned life insurance (COLI). 

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Here is how the plan can work. The company purchases a life insurance policy on a key employee, and the employee then defers compensation into the plan. The employee can decide how the funds in the plan are invested through a variety of investment options. The income and gains in the account can grow tax-deferred until withdrawn from the plan.

The employer can fund additional contributions into the plan but is generally not required to do so. The employee is always immediately vested in his or her contributions and earnings. Still, the company can contribute based on a vesting schedule that will require the employee to remain with the company or achieve certain goals.

Takeaway

Life insurance is not the best option for many people. But it can help you achieve many tax and financial planning goals. 

If done correctly, tax planning with life insurance can lower the tax consequences of life insurance decisions. To make informed insurance tax planning decisions, you must understand topics such as the tax-deferred buildup of cash value, the taxation of withdrawals, proceeds, loans, dividends, and premiums’ deductibility. 

Your insurance tax planning should also involve a general understanding of the advantages and disadvantages of types of insurance policies, modified endowment contracts, personal life insurance trusts, business use of life insurance, and life insurance as a part of a plan for charitable giving.

Paul Sundin

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