As Congress has squeezed the tax benefits out of many investments, life insurance has taken on a special glow. Policies that combine investments with insurance - including whole life, universal life, and single-premium life policies - enjoy tax-favored status.
Part, and sometimes a very substantial part, of the premiums go not to pay for insurance but into investments that build cash value. Earnings on the cash value are not taxed until you cash in the policy. If the policy is in force when you die, the proceeds go to your beneficiary completely free of any federal income tax.
There are ways to get at those earnings tax-free without dying for the privilege. Policyholders are permitted to borrow against the cash value in their policies. They are very special loans, too, since they never have to be paid back. Any loan outstanding at the time of death is simply deducted from the proceeds paid to beneficiaries. Although borrowers have to pay interest on the loan, in the sweetest deals the cash value in the policy earns just as much as the interest charged.
Insurance companies are always working to create policies that exploit the tax benefits of life insurance. And sometimes they're too successful. Consider, for example, a type of policy that was widely promoted as the last great tax shelter after Congress passed the Tax Reform Act of 1986: single-premium life insurance policies.
These policies have just enough insurance to qualify for the tax breaks; the remainder of the money is put into investments. As the name implies, you pay the premium only once and that buys you a paid-up policy. The death benefit is small, but the key here is the investment. With most policies, the entire premium immediately starts earning interest - or may be invested in your choice of various stock and bond funds - and starts building cash value. The cost of insurance comes out of your earnings.
Because the investment is wrapped inside an insurance policy, the earnings accumulate tax-free, just as money in an individual retirement account grows without annual interruption from the IRS. A $100,000 investment in a single-premium policy yielding 8 percent annually, for example, would grow to over $466,000 in 20 years. The same amount in a taxable investment would reach just over $271,000 in two decades, if annual taxes in the 35 percent bracket were paid out of investment earnings.
The sweetest thing about single-premium policy - before a congressional crackdown discussed below - was that the earnings could be completely tax-free. Although the earnings would be taxed if the policy were cashed in, investors could dance around the tax bill by borrowing against the policy. Many policies were designed so that there was effectively no charge for the loan. Interest on the loan was offset by earnings that continued to be credited to your cash value. Although structured as a loan, it worked like a withdrawal since such loans don't have to be repaid.
If that sounds too good to be true, it is. Congress has closed the door on tax-free loans from single-premium policies. Basically, unless you pay premiums for at least seven years, policy loans are considered taxable withdrawals. In addition to the tax, there's a 10 percent penalty unless you're at least 59 1/2 years old or disabled. There's an important exception for single-premium policies purchased before June 21, 1988. Those older policies retain the tax- and penalty-free loan feature.
Despite the crackdown on single-premium policies, other cash-value life insurance policies still sport the tax advantage of tax-free buildup of cash value and the loan privilege. Insurers were quick to create "seven-pay" policies to stretch premiums over a long enough period to maintain the policyholder's right to tax-free loans.
Some policies allow partial withdrawals of cash value, too. As long as the policy isn't caught up in the single-premium life rules, such withdrawals can be tax-free. The IRS assumes that the first money pulled out is a return of your premiums rather than the earnings. When withdrawals exceed your total investment in the policy, however, additional withdrawals are considered taxable income.
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