Tax Benefits of Whole Life Insurance

Unlock the secrets of mastering the tax benefits of whole life insurance with our latest Money Advantage podcast episode. We promise you’ll gain an in-depth understanding of tax laws related to life insurance strategies, like the pivotal 1988 government decision to limit cash value life insurance investments due to their tax perks. By diving into the historical context of the Tax Reform Act of 1986 and the Revenue Act of 1987, we uncover the intricate relationship between these laws and the economic climate of the time, helping you make smarter financial decisions today.

Travel back in time with us to explore how Nixon’s 1974 move away from the gold standard set the stage for inflation and the creation of IRAs and 401(k)s. These financial products shifted funds from whole life insurance, leading to the popularity of universal life policies. Our discussion reveals how high interest rates and regulatory responses like the 1988 Tamra Act reshaped the life insurance landscape, ensuring it remained a protection tool rather than a tax haven. The 1979 FTC report’s critique of whole life insurance also played a significant role, challenging traditional perceptions and influencing market dynamics.

We round off the episode by dissecting the Modified Endowment Contract (MEC) and the Tamra Act’s regulatory impacts on life insurance policies. Discover the nuances of the one-year and seven-year rules, the scenarios leading to a policy becoming a MEC, and the resulting tax implications. We delve into circumstances where intentionally MEC’ing a policy could be beneficial, such as for estate planning or achieving better returns than traditional banking options. This rich historical insight equips you with the knowledge to navigate today’s complex financial landscape with confidence.

Podcast: Play in new window | Download (Duration: 39:42 — 45.4MB)

Subscribe: Apple Podcasts | Spotify | Android | Pandora | RSS | More

Tax Loopholes vs. Tax Incentives

To kick off this conversation, let’s get something clear: tax loopholes are not actually loopholes. The word “loophole” has a negative connotation, and if often used to suggest that people who use tax incentives to reduce their taxes are doing something sneaky or unethical. The reality is that the IRS writes tax law to be as specific and intentional as possible, and those “loopholes” are actually intentional incentives from the government.

Tax incentives work to provide tax credits or breaks for investors who can do things that the government does not want to spend their own money on. For example, there are many tax incentives in real estate because housing is a constant and prevalent need. If housing cannot be provided by landlords, the government may have to provide more housing, and so the government creates tax incentives to have investors take the lead. 

Tax breaks don’t exist by accident. They are purposeful and are designed to get investors to take specific actions. 

Whole Life Insurance and Taxes

Whole life insurance is a popular “tax-advantaged” asset because you can technically access your cash in a tax-free way. You can do this through a policy loan, which must still be paid back, or by withdrawing only up to your base premium. Otherwise, you can still have a taxable event.

That being said, whole life insurance has long been a popular strategy for tax purposes, and in fact used to be even more beneficial from a tax standpoint, until the IRS got involved. And while there are some limitations, now, whole life insurance is still extremely advantageous from a tax standpoint.

The History of Whole Life Insurance and Taxation

Until the 1960s, whole life insurance was the premier savings vehicle for American families. It provided great flexibility and protection and was a powerful tax advantage. The cultural importance of life insurance was evident in its appearance in films such as It’s a Wonderful Life. 

“The social significance of life insurance companies sets them apart from other true financial intermediaries. In fact, the contracts offered by these institutions make it possible for broad layers of society to undertake a genuine savings discipline for the long-term.”

— Jesus Huerta de Soto

Whole life insurance does what very few other assets can do, enabling its owners to save without losses and to use cash in a tax-advantaged way. In fact, until the 1960s, there was a law that prevented policy loans from being more than 6%. While this was fine for a while, there was some big inflation in the 60s that the Fed was attempting to curb. At this point the interest rate on bonds went way up, so savvy policy owners were taking loans at 6% to purchase bonds at a much higher rate, earning them a steady return in a very safe asset. 

Because of this, insurance companies were finding that about 18% of their reserves were being taken up by policy loans, the highest percentage since the 30s. Because of this, they couldn’t do much with new premiums and instead had to hold them in reserves, rather than investing for themselves in the bond market. 

In 1974, our money was taken off the gold standard, the Fed started printing money, and IRAs came to play. It was around this time that people were becoming dissatisfied with the returns on their whole life insurance policy—which was happening because of policy loan caps and high proportion of policy loans—and it was decreasing in popularity. This led to the rise of Universal Life Insurance, a new and untested asset with a lot of desirability because it appeared to be more flexible. 

Then, in the 80s, the Tax Reform Act was passed, which removed tax shelters because they seemed to be “loopholes” and increased capital gains tax. This tanked the economy, and caused the wealthy to rush to whole life insurance because it had tax advantages, was accessible, safe, private, and guaranteed to grow. However, they would purchase these policies with single premiums because they wanted to protect whatever they had right away. Unfortunately, this caused the IRS to sniff around and ask the question: Are these really life insurance policies, or are they just glorified tax shelters? And so, the IRS passed TAMRA (Technical and Miscellaneous Revenue Act) in order to prevent people from using whole life insurance in this way.

TAMRA made it so that you could only contribute so much money to a life insurance policy before it was too much, and therefore disqualified it from being classified as life insurance. Once you hit that limit, it became a Modified Endowment Contract (MEC) and would lose any tax benefits. 

[25:06] “There were a lot of reasons why very smart people were putting money into life insurance policies before the 1970s… and then also in the 80s when there was a lot of volatility and instability in other markets.”

What Does it Mean to Be a MEC?

[28:50] “That MEC now simply means that the growth inside, instead of becoming FIFO (first in, first out)–-in other words, your premium goes in first and you can take your premium back out, which means you’re not going to be taxed on it—it becomes LIFO (last in, first out). This simply means that now the growth is what’s the ‘last in,’ so it’s got to be the first out.”

This means that you’re taxed when you take money out of the account. This restructuring of the account makes it much less efficient and heavily decentivizes paying for your policy in a lump sum. 

Today, it’s very difficult to MEC your policy unknowingly. Most insurance companies will alert you if you’re at risk of turning your policy into a MEC, and will offer to refund you some premium to prevent it if necessary. Of course, you can still choose to MEC your policy, but that’s your choice (and there are some reasons people do). Typically, a policy becomes a MEC by over-funding it in the early years of a policy. After your policy is in force for a certain amount of time, the IRS is no longer concerned with it, because you wouldn’t be able to over-fund the policy if you tried. 

Applying Whole Life Insurance tax Benefits Today

Today, the major tax benefits of whole life insurance still ring true. While you cannot fund a whole life policy without losing tax benefits, the long-term strategy of funding whole life insurance is still extremely beneficial. Imagine being able to store and grow your money, AND use that growth, without worrying about paying taxes. Imagine your death benefit passing to your heirs tax-free. These benefits have not gone away, and continue to hold water when compared to other assets that are taxable, volatile, and uncertain. Whole life insurance is something you can depend on.

Book A Strategy Call

Do you want to coordinate your finances so that everything works together to improve your life today, accelerate time and money freedom, and leave the greatest legacy? We can help!  Book an Introductory Call with our team today https://themoneyadvantage.com/calendar/, and find out how Infinite Banking, alternative investments, or cash flow strategies can help you accomplish your goals better and faster. That being said, if you want to find out more about how Privatized Banking gives you the most safety, liquidity, and growth… plus boosts your investment returns, and guarantees a legacy, go to https://privatizedbankingsecrets.com/freeguide to learn more.