The Basics of a Life Insurance Tax Shelter

The life insurance tax shelter is used by many individuals when engaging in financial planning. By purchasing life insurance policies strategically, an individual could potentially avoid paying a certain amount in taxes. Individuals can also use life insurance policies to plan for large tax expenses in the future. Here are the basics of a life insurance tax shelter.

Life Insurance Tax Shelter

The idea behind this strategy is to shelter income and investments from large taxes. For example, when an individual has large capital gains, they will have to pay a certain amount of money in capital gains taxes to the government. In order to avoid this problem, you could potentially invest in a life insurance policy. The proceeds from life insurance policies are not taxable.

For example, let's say that an individual came into possession of a large sum of money. Instead of keeping the money and paying capital gains taxes on it, the individual used the money to purchase a life insurance policy. At that point, he has a life insurance policy with cash value that he can access. This method will prevent him from having to pay taxes on the large sum of money that he received.

When you have a policy with a cash value, you could potentially take out a policy loan when you need money. Policy loans are very flexible and have very low interest rates attached to them. Most of the time, you can pay back these loans at your discretion. This allows you to have access to the money without actually paying taxes on it. If the individual passes away, his beneficiary would be able to receive life insurance payout without paying any taxes on the money either. In most cases, the payout on the life insurance policy will be much greater than the amount of money that you invested in the policy. 

Paying Tax Liabilities

Another way that life insurance can be used is to offset tax liabilities when an individual passes away. For example, if you know that your beneficiaries will have to pay a certain sum of estate taxes or other taxes on your assets, you could purchase a life insurance policy to offset these costs. This process can be difficult because you have to determine how much will be charged in taxes on an unknown date. In most cases, you should consult a professional tax advisor before implementing the strategy.

Once you determine approximately how much money your beneficiaries will owe in taxes, you can purchase a life insurance policy that will cover the entire amount. Since life insurance proceeds are not taxable, this will generate a source of money that your beneficiaries can use to pay the taxes with, without generating any extra tax liability for them. This will allow them to enjoy your entire estate without having to worry about paying taxes on it.