Is Cash Value Growth in a Life Insurance Policy Tax-Free? Part I

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tax-freeAs a recovering Tax Resolution Attorney I can tell you, there are two words the IRS hates more than anything. It’s not ‘tax deduction’, or ‘capital gains’, and it’s definitely not ‘tax-deferred’. More than any other two words the IRS hates are, “tax-free”. I have spent thousands of hours on the phone with the IRS, and never once has anyone been helpful in reducing taxes for my clients. So considering how stingy the IRS is, how is it that a whole life insurance policy will allow you to use the growth within the policy tax-free?

To understand how ‘tax free’ works in your policy, we need to understand the Modified Endowment Contract (“MEC”) limitation. This limitation is set by the IRS and is determined based on the amount of cash value you have in relation to your death benefit. To fully understand how a policy will become a MEC, please speak to an Agent at Paradigm Life and ask about the ‘Tamra 7-Pay Test’. When a policy becomes a MEC you lose the ability to utilize the growth tax-free. The policy will still perform the same way; the cash value will continue to grow and the death benefit will continue to increase, but any utilization of the cash value in the policy, including loans against the policy, will be a taxable event, until the growth has been exhausted.

There are limitations to using the cash value in your policy tax-free. There are a number of ways the growth in your policy may become taxable; for example, if the policy becomes a MEC, or if the policy were to lapse. To avoid these issues you will require proper structure of the policy, effective planning, adequate education, and ongoing support. In the event your policy lapses or becomes a MEC, utilization of the growth in the policy may cause a taxable event to occur, and the growth will be considered tax-deferred, and will be taxed as ordinary income.

There are many variables to consider, in order to make sure your policy will perform as advertised. The structure of the policy and the education to understand how the policy works are essential. This requires a specialist who deals with these issues daily. Contact us to request a free consultation.

Spencer Couch


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