Tax-Free Income

Title: Generating Tax-Free Income with Modern Cash-Value Life Insurance

Author: Thomas Swenson, J.D.

Published: December 16, 2022

Word count: 2,006

Tax-Free Income through Life Insurance: Is it Possible?

It may seem counterintuitive, but modern cash-value life insurance can be structured to provide tax-free income through loans from the insurance company to the policy owner. These loans are backed by the policy itself, and when the insured person passes away, a portion of the death benefit is used to repay the loans, while the remaining balance is paid to the policy beneficiary. In essence, this setup is similar to a reverse mortgage on a home.

Introducing Indexed Universal Life Insurance (IUL)

Indexed Universal Life Insurance (IUL) is specifically designed to offer greater flexibility, transparency, and cash value growth compared to other forms of cash-value life insurance, such as “whole life” policies. Cash value represents the value of the policy account after deducting policy costs from premiums. IUL stands out for its ability to generate tax-free growth in cash value, tax-free death benefits, and tax-free living benefits. (Unlike cash-value life insurance, term life insurance provides only a death benefit without cash value accumulation, meaning the beneficiary receives a payout only if the insured person passes away during the policy term.)

Premiums and Immediate Leverage

Typically, an IUL policy involves a specific number of annual premium payments (e.g., over 5 or 10 years). As soon as the policy becomes active, the death benefit is payable upon the insured’s death. Living benefits for serious, chronic, or terminal illnesses usually become accessible after a year or so. This means that premium payments immediately leverage substantial death and living benefits. However, to maximize cash value growth, the initial death benefit is minimized to reduce costs and allocate more premiums toward the policy’s cash value growth.

IUL for Income: A Long-Term Strategy with Liquidity

When considering IUL for income purposes, it is important to have a time horizon of at least 10-15 years after the policy is in force. During this period, the death benefit protection and access to living benefits remain available for the entire policy duration. IUL effectively leverages premium payments to provide significant benefits in case of premature death or certain illnesses. Moreover, the cash value of an IUL policy is always accessible to the policy owner when needed, ensuring liquidity.

Designing an Optimal IUL Policy

The design of an IUL policy plays a crucial role in maximizing cash value growth and income potential. Design considerations depend on the policy structure and, more importantly, the selection of policy options. A well-designed IUL policy minimizes the initial death benefit to enhance cash value growth, reduce costs, and ultimately increase the available income. However, it’s worth noting that to qualify for favorable tax treatment under IRC § 7702, a policy must provide a minimum death benefit amount. As a result, term life insurance is often included in the design. Unfortunately, some insurance agents prioritize maximum death benefit to increase commissions, which leads to higher costs, reduced lifetime income, and a higher risk of policy lapse.

Low-Risk Cash-Value Growth Linked to Market Indices

Cash value in an IUL policy is typically “linked” to one or more market indices, such as the S&P 500 fund or other index funds. However, there is no direct investment in these markets. The cash value of the policy account is periodically credited based on the growth of the linked fund during a specific period (e.g., one year). For instance, if an index fund shows a positive return of 14% over 12 months, the cash value may be credited at a rate of 10%. On the other hand,