The tax benefits of life insurance — and the risks to consider

Life insurance strategies could help wealthy families remove assets from their estates while acting as the collateral for loan financing and a source of tax-free distributions.

These possible benefits come with potentially high premium costs for a "whole life" or "permanent" policy instead of a fixed-term contract. The strategies also come with an array of complex planning questions related to trusts and estates and tax rules that are in flux this year and likely to remain that way for the foreseeable future. But the positives prove appealing for many wealthy and ultrahigh net worth clients, said Peter Harjes, a certified financial planner who is the chief financial strategist with life insurance and estate services firm ARI Financial.

"It's not necessarily the estate taxes per se — it's really the loans and the leverage and eliminating the uncertainty for their family when they're not here," Harjes said in an interview. "Having a vehicle that provides immediate liquidity to eliminate that uncertainty is more valuable to them."

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And, in most cases, the death benefit will not trigger taxes on the beneficiary — which is one of the many tax advantages of life insurance and related products. Just last week, the IRS issued a private letter ruling concluding that rebates on policyowners' premiums don't count as taxable income. The hefty premiums require careful cash-flow planning, but the policies could act as a hedge against inflation and, when paired with a trust as the beneficiary, they could offer a much more flexible means of passing down assets than individual retirement accounts.

"Usually, death benefits from employer-sponsored life insurance plans or private life insurance policies are tax-free," according to a guide to the pros and cons of life insurance by advisor matchmaking and lead-generation service SmartAsset. "Additionally, the cash value in whole-life insurance accumulates tax-deferred growth. This means that a person can reinvest the money in the cash value of a life insurance policy without facing tax implications. The policyholder will not pay capital gains on any dividends or growth on the cash value. But there are a few situations where life insurance may have some tax implications."

At its root, thinking through those ramifications comes down to whether a client would like to pay taxes on the seed or an entire garden, according to Harjes. 

Using cash-value insurance policies for tax-free loans, more

A "cash value" policy that assigns the leftover portion of a premium net of costs into an interest-earning account means that, "essentially we're creating a bond-like return inside of the policy without the duration risk," Harjes noted. In addition, the clients could take out tax-free loans against the policy or withdraw from the cash account without any tax hit, as long as the amount doesn't exceed their total premiums.    

"Using cash-value life insurance products, in general, really eliminates the uncertainty of where taxes go," Harjes said. "Private placement life insurance happens to be the biggest hot topic, simply because, when you're talking about trusts, you tend to hit the highest tax brackets quickly."

However, advisors and their clients should carefully consider the consequences of any movements of assets out of the account.

"It's important to note that withdrawing the cash value will reduce the policy's overall value and might increase the risk of the policy lapsing," according to a guide by insurance and brokerage firm Transamerica. "Policy loans are tax-free as long as the policy is active, but if the policy is surrendered or lapses, any outstanding loan amount is treated as a distribution and taxed accordingly. Generally, you'll only owe taxes on amounts that exceed the total premiums you've paid into the policy. A financial professional can help you understand the implications of taking a policy loan, including any potential taxes."

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The many factors and possible uses to consider add up to great reasons for advisors to discuss life insurance with their wealthy clients, Harjes said. He brought up an example of a billionaire real estate investor whose life insurance policy preserves the client's family-owned company as the collateral for hundreds of millions of dollars in financing and an asset to be handed to the next generation.

"The tax attributes alone make it a very successful product in someone's financial plan from a tax perspective," Harjes said.