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There is a thing between financial advisors which is rarely talked about, and it can reduce the tax you pay on 401(k) distributions after retirement. This is called variable life insurance.
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Created to link long-term investments from premium payments to a market rate of interest, these policies are an excellent investment, insurance policy and tax break for the right investor.
The variable life insurance tax benefits are essentially an IRS loophole of section 7702 of the tax code. This allows you to put money (after-tax money) into a policy that is invested in the stock market or bonds and grows tax-free.
Insurance policies provide a death benefit to a beneficiary, but also take a portion of your premium and invest it in stocks and/or bond funds for long periods of time. While this money is invested, you can switch in and out of tax-free investment sub-accounts. In a regular investment account, this is not allowed.
The idea is that you will hold the policy for 10-20 years, and if you see strong sub-account performance, you can pay the same amount each month for your premium while watching your cash value and death benefit increase.
Once the cost of insurance is covered (after X number of years, depending on your age, health and risk), your monthly premium amount may be reduced as your investments continue to grow.
Regardless of what happens in the market, and given that you have paid your premiums, your death benefit will always remain 100% tax-free for the beneficiary upon your death.
Variable life insurance as a retirement investment?
The most advantageous element for the policyholder is tax-free retirement income. Investors should be careful though, as the amount you withdraw could determine whether or not there are tax implications.
As Fed Week reported, you can access some of your cash value without having to pay income tax. When you want the money in your policy’s cash value, you can make tax-free withdrawals until you reach the amount of money you paid in premiums, Fed Week added.
For example, while variable life insurance policy money is tax-exempt up to the amount of the premium, the money you take out of your 401(k) will be taxed. If you withdraw $1,000 per month from your variable life insurance policy, that’s $1,000 less than you need to withdraw from your 401(k). Since there is no way to know what tax rates will be in the future, this could save you a lot of money.
Add a Roth IRA that you’ve also contributed to for the past decade or so, further reducing your taxable amount while allowing investments to grow. A Roth IRA is another great investment vehicle to invest after-tax money in, but unlike a variable life insurance policy, there are limits to the amount that can be invested.
As Fed Week said, “The bottom line is that variable life insurance can provide you with tax-free retirement income, provided you use the policy carefully, and a tax-free death benefit for your loved ones. .”
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Why is variable life insurance an incentive?
There are several reasons why the government allows this. First, it incentivizes people to buy life insurance and, second, this incentive will reduce, in the long term, the financial liability that the government will have to pay pension benefits. If more citizens look to the markets for reliance on their retirement, so much the better for a crumbling social security system.
The government also understands that the costs make these policies too expensive to pose a significant threat to incoming tax revenue. The average American cannot afford the roughly $500 a month initially needed to purchase these policies. The cost of insurance hovers between $200 and $300, and an additional $200 is usually needed to make worthwhile investments.
It is important to note that, as with all other investments, relevance is paramount. Specifically with long-term investments like an annuity or life insurance, investors often don’t have access to their capital for at least seven years. Normally policies are designed not to make financial sense unless there is at least a 10 year investment period. The prospectus provided by financial professionals will outline the details, and these types of investments should always be purchased under the guidance of licensed advisers or brokers.
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