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TAX-FREE INCOME.
(Why it's tax-free.)
Why is the income received from Defined Benefits Life free of income taxes? The reason is that, under current law, the income that comes to you at retirement is in the form of annual policy loans. For the purposes of income taxes, loans against the policy are considered to be simply advances against the policy's dealt benefit, which is tax-free in any case. At death, any outstanding loan amount is subtracted from the life insurance policy's death benefit.
Consider the example of a policy with a death benefit of $2,000,000 and a cash value of $1,500,000. If the policy owner takes policy loans of $100,000 per year for 15 years ($1.5 million total), that is income tax-free, even though the amount withdrawn may be significantly higher than the sum of the premiums paid into the policy. At death, the beneficiary would receive $500,000- the $2,000,000 death benefit minus the total of loans taken.
Age 35
Purchases policy. Pays premiums to age 65.
Age 65
Begins to take policy loans of $100,000 annually.
Age 80
Has taken policy loans for 15 years, totaling $1,500,000.
If the man dies at age 85, his beneficiary receives the net death benefit equal to:
Gross Death Benefit - Outstanding Policy Loans Amount
$2,000,000 - $1,500,000 =
$500,000 income tax-free.
In order for the policy loans to be truly tax-free, and in order to avoid a taxable event, the life insurance policy must be in-force at the time of death. Otherwise, the outstanding loans amount` cannot be considered an advance against the death benefit. Therefore, caution must be observed to be certain that the policy does not lapse. Fortunately, today's policies typically have provisions that prevent the policy from lapsing.
Consult your tax advisor with any questions you may have.
TAX-DEFERRED GROWTH.
(Why it's better while on your journey to retirement.)
As cash values build in the life insurance policy, they do so without income taxes. This treatment under current law is called tax-deferred growth. Over time, more money will be accumulated when taxes are deferred. The reason is a 3-part benefit: Policy owners earn interest on the cash value, interest on the interest earned, and interest on money they would otherwise pay in taxes each year.
In the event the policy is surrendered, income taxes would be payable to the extent of any gain.