Is Whole Life Tax-Free?

blocks that spell the word tax. Is whole life tax free?

Language is one of the most important tools we have to get concepts across to clients. Language has the power to create understanding and foster connections, and it also has the power to mislead or misrepresent. When building trust, the words we use about our products are crucial, so that we don’t contribute to the misinformation in our field. One shining example is the way we discuss taxes and tax strategies, or call whole life insurance tax-free as a blanket statement. Language like loopholes, shelters, and tax breaks can all carry negative implications, for example. 

These phrases don’t just carry a stigma, either, they also demonstrate a greater misunderstanding of what tax advantages are, and why they exist, to begin with. These misunderstandings also tend to extend to financial products, like whole life insurance, which has certain tax advantages. 

For example, advisors and clients alike tend to throw around the words tax-free when talking about life insurance. This leads to many misunderstandings about how life insurance works and is taxed. While the death benefit is truly tax-free, and there are ways of accessing cash value without creating a taxable event, to say it’s completely tax-free is dishonest. 

In part, this is because talking about the “tax-free” benefits of life insurance is alluring. People perk up when they hear this, and they may not hear the whole context of the tax-free discussion. Which can cause problems down the line; especially if they inadvertently create a taxable event. 

Our industry doesn’t need more misleading, gimmicky language to attract clients. Instead, we should be looking more deeply into our products and understanding their design. And, we happen to think that whole life insurance is taxed exactly the way it should be, with no “special” tax provisions.

Whole Life Insurance Taxation Explanations

Tax-Deferred Growth

Consider all of the existing tax-deferred assets like stocks, real estate, qualified plans, and so on. 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. 

Growth in whole life insurance policies is also assessed on a tax-deferred basis. We believe, given how the asset is constructed, that this tax treatment is fair. That’s because, in order to liquidate a policy, one must surrender paid-up additions and death benefits. There’s no annual distribution, and most people choose to access their cash values indirectly via policy loan, rather than surrendering all or a portion of the policy. 

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 one of the primary reasons dividends are deemed tax-deferred. 

This is because the mortality and operating expenses of a whole life policy are charged at the maximum. (Universal life, on the other hand, charges these expenses at a varying rate, which may lead to 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 full dividend also includes profits). 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 as opposed to profits. 

In our 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 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

Taxes are not paid 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. Language is important here, because of where the money comes from. For example, you can get a loan from your Qualified Plan, but the money is pulled FROM the account, reducing the total account value until repaid.

The Qualified Plan loan can become taxable if the owner of the plan loses his job or liquidates the plan. The same is true for a loan from the life insurance company. 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

We’re of the opinion that this is not a special consideration or loophole. The tax-free death benefit is precisely as it should be. After all, 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 auto or homeowner’s insurance, 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? That’s the thing about life: opportunity abounds. The insured may have been on the cusp of a breakthrough that would bring major financial success. 

When property insurance is distributed to you, you don’t pay taxes on any excess just because your property could technically be replaced with less. Perhaps property and casualty insurance companies should start advertising their “tax loophole” of distributing tax-free money when you lose your car or home.

Tax-Free: Mean What You Say

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 “tax loophole” angle (despite the negative connotations attached). 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, yet only if it fits the strategy. We would argue that letting the “tax tail wag the financial dog” by avoiding tax “no matter what” can be detrimental. Ultimately, being so singularly focused on being tax-free can keep you and your clients from seeing the bigger picture.

So often, people attempt to avoid or postpone tax and end up spending more money than if they had just paid the tax (as often happens with interest, too). We see this phenomenon in all areas of investment—yet, especially with real estate. For example, some investors will overpay 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 (not eliminate) a capital gain 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 transparency. And we should always 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. 

The primary reason it’s critical to be transparent with our language 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. And they just might tell everyone they know about this poor experience.

2. Change in taxation

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. In other words, the IRS or the government could step in with any number of changes to life insurance taxation (though we’re seeing some positive changes with the new 7702 adjustments).

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. 

If you’d like to expand your understanding of the whole life insurance industry and sales strategies that center truth and transparency, we’d love for you to join our PEA mentorship program. If you have questions about which level will be the perfect fit for you, we encourage you to talk with our community caregiver, Janet Sims at janet@pem.email.

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