Tax language—you’ll often hear talk about tax loopholes, tax breaks, tax shelters. All have a negative implication and show a fundamental misunderstanding of why tax advantages exist in the first place. Whole life insurance taxation is another beast altogether.
With whole life insurance, I often hear people talk about how it’s tax free, which is equally misleading. While the death benefit is tax free and there are ways of accessing cash value without causing a taxable event. To say it’s entirely tax free is incorrect.
And yet (outside of one area) I feel whole life insurance is taxed exactly the way it should be, with no “special” tax provisions.
Whole Life Insurance Taxation Explained
Tax Deferred Growth
Consider other tax-deferred assets like stocks, real estate, and even qualified plans. These assets are held, rather than distributed to the account holder. As such, any taxation is not assessed until the asset sells (or is accessed, as with qualified plans). No annual tax is paid upon the increased valuation of the asset.
The same is true with whole life, and it should be. That’s because, in order to liquidate a policy, one must surrender paid-up additions and death benefit for liquidation. Money is not distributed to the policy owner annually to be taxed. This is because all or a portion must be surrendered to get the cash directly.
Patronage Dividends
Dividends from an electrical (or other) Co-op aren’t taxable because they are a return of overpayment. The same is true for a majority of the whole life dividend. This “overpayment” status is actually a primary reason for deeming dividends tax-deferred.
This is because they charge mortality and operating expenses of a whole life policy at the maximum. (Universal life, on the other hand, charges at a varying rate, which could cause insufficient funding.) When the insurance company has a better mortality experience than they charged for in the premium, companies return the excess as a portion of the dividend. The same is true for administrative expenses.
Because of the low interest rate environment we’re currently experiencing, most of the dividends people are receiving this year are from those overpayments.
In my opinion, dividends should actually be tax free, as with patronage dividends.
First in First Out (FIFO) Tax Treatment
Under this taxation rule, the non-taxable principal basis is distributed first, followed by the taxable earnings. You could consider this “special” tax treatment, as an advantage for life insurance cash value distributions (surrenders).
Most, if not all, other tax-deferred vehicles are taxed in one of two ways. LIFO (last in, first out) is the first. It means that the earned interest is taxed before the basis (tax free principal) is distributed. Annuities and Modified Endowment Contracts (MECs) are good examples of this treatment.
The other way tax deferred vehicles are typically taxed is on a ratio of both the tax free principal basis AND taxable interest earnings. IRAs that have after-tax contributions would fit this taxation.
No Tax on Loans
We never pay a tax on loan proceeds. This is not a special consideration for whole life insurance. When you have a whole life policy, you borrow AGAINST the policy. Meaning, you put your cash value up as collateral in order to secure a loan from your insurance company.
(Compare this to a Qualified Plan loan, where money is borrowed FROM the asset, and is removed from the total account value.)
This loan can become taxable if the owner of the plan loses his job or liquidates the plan. The same is true for a whole life policy. If the policy lapses or is surrendered, the proceeds from the cash value are used to pay the loan in the form of a distribution. So the gain, if any, is taxed.
The Death Benefit is Income Tax Free
Again, I feel that this is as it should be—not a special tax consideration. The purpose of the death benefit is to insure the Human Life Value (HLV) of the insured. There is a reason you have to apply for insurance, and you aren’t entitled to whatever amount you want. Insurance companies have underwriters who determine this value based on income and gross worth. The death benefit is merely the indemnification of a loss.
Just like property insurance like auto or homeowner’s, there is no income tax to pay on proceeds meant to cover a loss. Even if it could be argued that the payout might be more than the insured’s human life value, who is to say for sure?
Do you know if the insured individual might have created something of ultimate value, but was cut short? Do you have to pay tax on the excess distribution of property insurance when the asset could technically be replaced with less?
Perhaps property and casualty insurance companies should start advertising the “tax loophole” of distributing tax free money when someone loses their car or home.
Whole Life Insurance Taxation Gimmicks
Unfortunately, whole life insurance is not exciting enough for some of the people selling it. So, they attempt to make it sound more “sexy” by adding tax free language around it, and pushing the negatively perceived “tax loophole” angle. The truth is that it is a tax deferred asset, as it should be, and has a tax free death benefit for the indemnification of a loss, as it should be.
With the correct strategies supporting it, there may (ideally) be no income tax on the use and distribution of the asset, but only if it fits the strategy. I would argue that letting the “tax tail wag the financial dog” by avoiding tax at all costs can be detrimental. That’s because it often keeps people from taking a few steps back and seeing the big picture.
So often, people attempt to avoid or postpone tax, and end up spending more money than if they had just paid the tax. We see this phenomenon in all areas of investment–especially with real estate. Many people will pay too much for a property because they’re under a time crunch for a 1031 exchange from the sale of a property. They overpay so they can DEFER (no eliminate) a capital gains or depreciation recapture tax.
Unfortunately, the same fear of tax often obscures logical thought, resulting in poor economic decisions in all aspects of saving and investing. Yes, even with whole life insurance.
We don’t call real estate a tax free asset just because we could die with it and get a step up in basis. And we shouldn’t do it with whole life insurance either. We should be open about whole life being a tax deferred asset with a tax free death benefit.
Don’t Compromise Your Credibility
Ultimately, it comes down to truth. And we should be truthful and transparent with clients—not gimmicky. After all, the true nature of whole life insurance shouldn’t make it less desirable. It’s just as useful whether you call it tax free or not.
My main concern is two-part.
1. Credibility
Say a client hears the tax free language and gets insurance. Then a life event causes them to deviate from a tax avoidance strategy, and they’re forced to liquidate their policy. They’re going to be an unhappy camper when they realize there is tax due on their gains.
This misleading information is ultimately a lose-lose. The client loses confidence in you and the asset.
2. Change in taxation
I don’t have much faith in the intelligence of the IRS or the federal government. I fear the continuous misuse of the tax free and tax loophole language may have adverse effects in the long run. While it’s meant to make insurance sound more appealing to potential clients, it may actually catch the attention of a group seeking more revenue.
I would argue that they would have to make a special tax law to do anything about it (based on the earlier taxation breakdown), but I’d rather not tempt fate.
The bottom line? Don’t let gimmicks ruin the credibility of the asset or the industry, and certainly not your own practice. Whole life insurance is useful whether or not you call it tax free—so focus on the truth. That’s what will bring integrity back to the business.
To learn more about whole life insurance, I encourage you to attend a Truth Training. In 3-days we’ll cover how to use Truth Concepts software, as well as big-picture concepts like the above.