Proper tax planning should do two things: reduce your taxes while you are alive, as well as after you die. Permanent life insurance gives you the potential to cover these two bases at once - you can transfer your assets income tax and estate tax free to beneficiaries and also build up tax-deferred growth of cash inside the policy.

Read on to discover how to make the most of this important tax planning tool.

Your Beneficiaries
When people think about life insurance, they generally envision how it will help those they leave behind. So, first let's talk about what life insurance does for your family. It can let you pay for a child's future college education, provide a retirement fund for your spouse, or simply make sure your survivors have the money to live the lifestyle you want for them.

Life insurance gives you the ability to transfer a policy's death benefit income-tax-free to beneficiaries. No matter how big the death benefit is - $50,000 or $50 million - your beneficiaries won't pay a single cent of income tax on the money they get. What other investment does that?

For instance, beneficiaries can get walloped by the IRS when they inherit IRAs, tax-deferred annuities and qualified retirement plans. They could end up losing up to 35 cents out of every dollar you leave them to federal income tax.

This is not the case with life insurance. Also, life insurance guarantees that your heirs will get that money. (To learn more, check out Buying Life Insurance: Term Versus Permanent.)

What's in it for you?
The mounting federal deficit, the long-term healthcare crisis and the uncertain future of Social Security and Medicare have put the government safety nets deep in the hole. And it's probably not going to get better during your lifetime.

But you can take comfort in knowing that the tax-deferred growth of cash inside a life insurance policy is not vulnerable to the whims of the people who run Social Security and Medicare. This is money that you could use to supplement your retirement income, pay for medical care, or whatever you wish - regardless of what the government does.

That's not all. If you are collecting Social Security income, you might not know that could have to pay income tax on up to 85% of those benefits. Also, most taxable income, and even tax-free municipal bond interest, is counted when determining how much of your Social Security you can lose to the IRS. This is not the case with life insurance. Earnings that grow within a life insurance policy are one of the few items that will not increase the tax on your Social Security income.

Strategies To Use

  • Irrevocable Life Insurance Trusts
    If you and your spouse have a net worth of more than $4 million, take a look at an irrevocable life insurance trust (ILIT).

    You make a cash gift to the ILIT to purchase a permanent survivorship life insurance policy. The ILIT is the owner and beneficiary of the policy. When the survivor dies, your heirs will not have to pay estate and income taxes on the death benefits.

  • Give It Away Now
    If you're of more modest means and would like to see your money working for your heirs while you're still alive, as well as increase the amount they'll receive when you die, then you might want to consider giving cash to them today.

    For the greatest benefit, your heirs can use part of the gift to buy a life insurance policy on your life. Meanwhile, you'll be able to watch your loved ones enjoy the remainder of the money - right now.

    What's more, you'll reduce your taxable estate by the amount of your gift. And, because your loved ones are the owners and beneficiaries of the policy, they won't have to worry about estate or income taxes on the death benefit when you die. They also won't have to worry about paying income taxes on the growth of the policy's cash value while you're living. (To learn more about this strategy, read Shifting Like Insurance Ownership.)

Life Insurance Solves Other Tax Problems
Asset Allocation
There are several versions of permanent life insurance. Some, such as universal life (UL), pay a fixed interest rate on the cash within the policy. Others, however, such as variable universal life (VUL), offer dozens of investment options. These might include a large-cap stock fund, an international stock fund, a bond fund, or even a real estate fund. The list is nearly endless.

The growth of the cash value in VUL is determined by the performance of the underlying portfolio(s) you . This becomes part of your total investment portfolio. Reallocations within the policy are not taxable. So, when it comes time to rebalance your investments, you won't have to worry about paying income tax on profits you take as you make changes in the VUL.

Maxed Out Retirement Plans
If you contributed the maximum amount to your 401(k) and IRA this year, it's important to know there are no restrictions on how much you can put into permanent life insurance. Plus, you'll at least gain the advantage of tax-deferred growth, and you'll leverage the value of your estate.

Remember, however, that if you later take cash of out the policy, you'll have to pay taxes on it at your ordinary tax rate. So, don't look at this as a substitute for a cash emergency fund. That said, the policy might have a loan provision that lets you borrow from your cash value and thus avoid the tax.

Shelter From Higher Taxes
If you think that income and estate taxes will skyrocket, permanent life insurance can help you transfer wealth into a shelter that protects your assets from higher taxation.

Pennies on the Dollar
If income and estate taxes keep you awake at night, life insurance might be the answer. Permanent life insurance is one of the most powerful tax planning tools you can find. It offers several unique ways to address your estate tax and income tax liabilities while resolving those tax issues for pennies on the dollar.

If you use this strategy, next April 15 could seem like just another pleasant spring day.

To continue reading on this subject, see Permanent Life Policies: Whole Vs. Universal.

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