Tax-Free and Tax-Deferred Income Strategies

Now that you understand the basics of investing in life insurance and annuities, let’s delve further into using specific strategies to achieve tax-advantaged income.

Strategy #1. Using Life Insurance Cash Value for Tax-Free Income

The big question is how to get guaranteed income in retirement that’s tax-free. That’s the dream for everyone. It’s not always easy or possible, but that’s obviously the goal you want to approach as closely as possible.

What would happen if you only used your life insurance cash value to fund your retirement? All your income in retirement would be tax-free.

For this strategy to work, remember: you don’t want to cancel your life insurance policy, because the minute you do, all your investment gains are taxable. However, as long as you keep your insurance policy in force, you can borrow money from it.

When you borrow money, since it’s a loan, it doesn’t count as income, so you don’t have to pay any taxes on it.

So each year, maybe you borrow $30,000 from your life insurance.

When you eventually die, the death benefit from your policy will pay off your loans so nobody else has to pay it. Life insurance death benefits are tax-free, so your heirs never have to pay tax on your investment gains or on the rest of the money they receive.

Important Considerations

Keep these facts in mind when considering this strategy:

  1. Tax-free, but not guaranteed. The downside with using life insurance for your retirement income is that it only achieves the tax-free goal. It doesn’t meet the guaranteed goal.
  • It’s up to you to figure out how much money you can take out each year so it doesn’t run out. So there’s a chance you can outlive your money.
  1. How much do you want to leave for your heirs? The one thing you need to balance out is your income requirements versus if you want to leave an inheritance.
  • When you borrow money from your policy, you also deduct against your future death benefit for your heirs. For example, if you want to leave $300,000 to your grandkids but you spend $200,000 of your $300,000 life insurance policy, they’re only going to receive the $100,000 balance.
  • Just be aware the more you spend from your policy, the less you’ll leave to your heirs.

Strategy #2. Using an Annuity to Guarantee Income for Life

When you invest in an annuity, you already know that the main benefit is guaranteed income.

So if you have $300,000 in your annuity, you can ask the company to turn it into guaranteed payments for the rest of your life.

That way, no matter how long you live, you’ll receive the same amount of money per month. If you live to 120, you know you’re still going to be collecting checks. That’s a good tool, especially since we’re living longer than ever.

Tax Treatment of Annuity Payouts

Another benefit of annuities is that they’re tax-deferred, which means the government doesn’t tax your gains while they’re in the account, but when you start collecting payments, your investment gains are taxable.

When your taxes are deferred, your money grows faster because there’s more money to work for you throughout your accumulation phase.

When you start receiving payments, part of those payments is considered to be the money you put in and the other part comes from gains. Only the part that comes from your gains is taxable, since you already paid income taxes on the money you used to fund your policy.

The payments are divided into taxable and non-taxable portions based on the same proportions they make up in your account. For example, if half of your account is what you put in and half is from your gains, then your payouts reflect that same 50/50 split. Half of a payout check is taxable and half isn’t.

Important Considerations

Annuities work really well, as long as you plan properly and know it’s for your retirement savings.

Keep these points in mind when using annuities to fund your retirement:

  1. Choose carefully when you decide how long you want payouts. If you’re choosing the guaranteed life option, it works great if you’re going to live a long, long time, but it can be an issue if you die early.
  • Say you’re 65 and you choose payments for the rest of your life, but you only live one more year. You’ve probably only collected $4,000 of your $300,000 annuity, using our same example as before.
  • Fortunately, you don’t have to choose only the guaranteed life option. Many annuities let you set it up where you say, “I want it for the rest of my life, but I want a minimum of 10 years worth of payments.” Or you might choose a minimum of 15 or 20 years.
  • That means if you die in one year, at least your heirs will receive payments for the rest of the term you chose (9, 14, or 19 more years based on your option).
  1. Wait as long as possible before you start payouts. If you start receiving guaranteed payments when you turn 60, you’ll receive less money per month than someone that waited until 70.
  • The longer you can stretch out your accumulation phase, the more money you’ll get per month in your payout phase, regardless of which option you choose.
  1. Avoid withdrawals before age 59 ½. If you get stuck in a money jam and you need to take money out when you’re 50, like just a lump sum withdrawal, the IRS charges a 10 percent early withdrawal penalty, which really hurts your investment gains.
  • So if you’re putting money into an annuity, plan to lock it in until you’re at least 59 ½.

Strategy #3. 1035 Exchange: Life Insurance Cash Value into an Annuity

Just because you use one product, doesn’t mean you can’t use the other. Perhaps you no longer have a need for life insurance and now you want those guaranteed payments of an annuity because you’re retiring.

It’s a really easy switch to turn your life insurance into an annuity!

You simply perform a transaction called a 1035 exchange. Your insurance company will have the forms to fill out. This will take all the money from your life insurance and deposit it into an annuity.

This transfer doesn’t count as a withdrawal, so you won’t owe any taxes on this move. It will just be like you had saved in an annuity all along.

From there, with your new contract, you can set up the guaranteed payments for retirement.

Change Your Plan as Your Needs Change with No Tax Consequences

Your financial needs change over time. When you’re in your 30s with children, you need the life insurance, but once you’re in your 60s and the kids are gone, you might not.

So this is an exit strategy. There are no taxes involved.

Maybe you don’t have quite as much money as if you had just used an annuity your whole life, but you may have needed life insurance, so that wasn’t an option anyway.

Important Considerations

  1. This is a one-way street. You can turn life insurance into an annuity tax-free, with a 1035 exchange, but you can’t go the other way. You can’t turn your annuity into a life insurance policy.
  2. It’s a permanent decision. It’s also important for you to know that once you make this move, you’ve lost your insurance. You can’t change your mind a couple years later and get it back.
  • As you get older, your health may change and it will be harder to qualify for life insurance. So you may be giving up that opportunity for the rest of your life.

Strategy #4. Using an Annuity + Life Insurance

Use this strategy to maximize your benefits by using both life insurance and annuities.

If you’re married with an annuity and you want guaranteed payments for retirement, you have two options:

  • You can base the annuity on both your lives, which means as long as one of you is alive you’re going to be collecting payments, or
  • You can base payments based on one person, for example, just basing it on the husband. However, if the husband dies, the payments stop, so the wife wouldn’t have any more income.

When you base an annuity on one person, it’s obviously a lot riskier, but you get significantly more money. Depending on the age, you get 20 or 30 percent more per month.

If you base it on two people, you get less money, but at least it’s a safer retirement.

The Solution:

As an example, a husband could get life insurance on himself and then do the annuity based on his life, because as long as he’s alive, they’re collecting that larger income.

If he dies first, the annuity payouts would stop, but his wife would collect the death benefit from the life insurance (tax-free), which she could use to fund the rest of her retirement. Hopefully, they both live very long and collect that higher income for the rest of their lives, but then they’re also protected in case the annuity spouse dies.

If the wife dies first, the husband keeps getting the higher annuity payments he has been getting all along.

For this strategy, because it’s a bit more complicated, it’s important to sit down with a life insurance agent or financial planner to make a plan that works for your situation.

You can get always get free annuity and life insurance quotes online, but when you’re doing a more complicated strategy like this, it helps to sit down with a professional. You don’t want to make a mistake here.

Younger vs. Older Investors

It’s better to plan sooner with this strategy.

If you’re in your 30s or 40s, that’s the time to buy the life insurance policy because you’ll likely be healthy enough to qualify for an affordable rate. If you wait until you’re in your 60s or 70s, you can’t really do this anymore, because you won’t be able to buy a large enough policy, and you might not be able to qualify at all.

You can get the annuity at any time, but if you get it when you’re young and add funds to it on a regular basis, you have the advantage of letting your money work for you for many years of tax-deferred growth before you switch it to the payout phase.

Comparing Tax Advantages of the 4 Strategies

The only strategy that is completely tax-free is just using life insurance (strategy number one).

Anytime you use an annuity, you’re going to end up paying some taxes on your investment income. Unfortunately, there’s not really a way to get guaranteed income for life without an annuity, which means paying at least some tax.

Strategies two, three and four do delay taxes until retirement, which gives your investment more momentum to grow. Plus, with annuity income, only part of each payout is taxable.

You’ll pay less tax with strategy number four, where you use life insurance and an annuity, because the life insurance death benefit will be tax-free.

How can you get started?

Typically, both these products are offered by insurance companies.

If you would like to invest in an annuity or life insurance, it’s best to get a few quotes from different companies to see which ones look best. For your security, you’ll want to use an insurance company that will most likely be around many years from now when it’s time to get payouts, so choose one with A+ ratings from the A.M. Best Company.

You usually need to see an agent and sit down for a meeting before they’ll prepare a quote for you.

However, there are companies online that specialize in putting together rate quotes. For example, AnnuityQuotes.com will send you a few quotes from major companies if you enter in some information.

Points to Ponder

It’s really something to consider, this match up with life insurance and annuities. We’re at a time when most of us don’t have pensions, so it’s hard to find a way to guarantee income in retirement.

This really became clear a few years ago when the market crashed. Stock portfolios were falling apart and interest rates on bonds and bank accounts disappeared.

Setting up an annuity with guaranteed income is really the only way now for most people to get income for the rest of their life. The tax advantages are just icing on the cake!