How To Read A Life Insurance Illustration & Using Life Insurance For Tax Minimization - Part 1
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Life insurance is one of those items that people really don’t like to talk about. Its complicated. It is uncomfortable and acknowledges we all will die way too soon. Its expensive.
But, life insurance is one of the most important pieces in your financial plan. It is there to protect your loved ones in case you die unexpectedly and can have immense benefits for not only estate planning, but also tax minimization.
Unfortunately, because it is complicated and appears expensive, it is shunned by the budgetpoor community. The amount of “anything but term is a scam” posts I see weekly is sad.
Yes, term is cheap and gives you death benefit protection if you die young. But that is only 1 of the many benefits of life insurance.
An equally as important aspect is tax minimization. Which is something term doesn’t offer at all.
I have written extensively about basic insurance coverage:
These posts (free and paid) offer a trove of knowledge. But so far I have focused on the death benefit aspect of insurance. If you are young and/or still accumulating wealth, that is the important part to focus on.
[Note - This post will assume you have read the prior ones and will glaze over some concepts. If something seems vague here, go back and find it one of the prior posts]
However, at some point, you are already maxing out all of your standard tax-advantaged accounts (401k, IRAs, HSA, etc) and contributing to a taxable brokerage. At this point, there is a shift in how you think about money.
You are in a higher tax bracket and expect to be in a high bracket in retirement
You know all your pre-tax qualified money (Trad 401k, Trad IRA) will be taxed in retirement and RMDs will make it so you can’t avoid the big tax liability
You look at the ballooning debt and assume taxes likely go up
You know saving 30% tax hit on your assets when you drawdown is massive compared to anything else you can do
At this point, tax minimization is paramount.
There are many ways to lower taxes - Real Estate, Legal structures, businesses, etc. But one often underutilized one is good old, boring life insurance.
This post will go over one method of using life insurance to get a lot of tax-free income in retirement.
But first, to address one of the many criticisms about life insurance….
“No one ever got wealthy from life insurance”
This is another line repeated over and over from the budgetpoors to dissuade people from life insurance.
The message isn’t necessarily wrong - life insurance isn’t an income producing business. If you buy a policy it won’t MAKE you wealthy.
But the implication that the wealthy don’t actually use life insurance as a tax haven is absurd to anyone who has a passing familiarity with the industry.
In a prior role at a major life insurance company, I had to approve the jumbo insurance policies. People were buying $100s of millions of life insurance coverage and dropping in $10s of millions of dollars into the policy. These would come for approval multiple times a week.
Life insurance can be such an effective tax haven, that Congress had to pass laws to make it less effective. In the 80s people were using life insurance as a tax avoidance scheme.
To overly simplify it, people would take $1mm put it into a ‘life insurance policy’ for $1mm of coverage, pay almost no fees on the policy, and then never have to pay taxes on it.
So in the late 1980s Congress passed laws defining life insurance, setting limits to how much cash you could put into a policy before it was considered an investment, and other various changes (DEFRA, TAMRA, 7702 & 7702A, Modified Endowment Contract (MEC)).
MECs are if you put in too much money relative to the amount of insurance and you lose the tax benefit. This was specifically created because life insurance tax laws were too awesome.
In short, life insurance can be a tremendous tax minimization play, so much so Congress had to pass multiple laws to rein it in, and wealthy still try to maximize it today. So yes - the wealthy did and still use life insurance to be wealthier, even if it wasn’t the driver of their initial wealth.
If none of that makes any sense, I’ll briefly hit on the basics of how this works for some background.