Taxes are always a problem for affluent Americans. Fortunately, taxpayers still have access to many tax-advantaged programs, including tax-deductible retirement plans such as IRAs and 401(k)s, tax free municipal bonds, and tax-deferred investments such as annuities and tax-advantaged life insurance. Many investors may not be aware that certain life insurance policies can provide tax benefits.

Types of Insurance Policies
There are two basic types of life insurance; term and permanent. Policyholders of term insurance pay a premium in exchange for a specified death benefit. Permanent life insurance policies provide a death benefit and build cash value. Examples of permanent policies include whole, universal, and variable life.

The method of payment can have an impact on the taxability of the policy. Premiums can be paid periodically, usually in annual installments. If they follow certain guidelines for life insurance tests, these policies can enjoy tax deferral on the growth of the cash value and on distributions, either by withdrawals or loans, using a first-in, first-out basis. This means that all distributions up to basis are received income tax-free. More significantly, upon the death of the policyholder, the proceeds are income tax-free to the beneficiary.

Policies that are paid by a single premium and purchased after June 21, 1988 are called modified endowment contracts. These policies are treated differently than pre-1988 single premium policies and periodic payment policies. Earnings on these policies grow tax-deferred and the death benefit is usually income tax-free. However, the cash values from single premium life policies are treated like tax-deferred annuities, whereby distributions from modified endowment contracts are treated on a last-in, first-out basis. If the owner is under age 59½, Uncle Sam assesses a 10% tax penalty on withdrawals of earnings from a single premium life plan just like an annuity or an IRA.

Important Facts about Variable Life
For policyholders who want to exercise control of their investments within a life insurance policy, variable life accommodates their needs. Premiums pay first for the term insurance cost and the remainder is invested into separate accounts similar to mutual funds or variable annuities. The separate account may also be a fixed account, in which there is a stated rate of return for certain periods of time. Assets in variable separate accounts are protected from creditors of the insurance company. Fixed accounts are usually general accounts of the insurance company and are not protected from these creditors. Always ask to see the prospectus for a variable life policy. Variable life policies can be useful for education and retirement funding.

Selecting the Right Policy
Selecting the appropriate permanent life insurance depends on several factors, such as the purpose of the policy, age of the policyholder, and the policyholder's risk tolerance. If the policyholder primarily purchases life insurance for the death benefit and a level premium, a program with a structured premium, such as whole life, may be appropriate. Premiums are required for a fixed period of time until enough cash value exists so that the policyholder can stop paying the premiums out-of-pocket. Commonly used for estate and business planning, a whole life policy is desirable where a guaranteed death benefit and a guaranteed level premium are important.

If the policyholder desires more flexibility in premium payments or cash accumulation, universal life insurance can provide these benefits. For example, a universal life policy pays a stated interest rate, usually changed annually. Also, policyholders have premium payments paid internally if the policy has enough cash inside the policy.

Although the death benefit from a life insurance policy is usually income tax-free, the death benefit is included in the estate of the policyholder and subject to an estate tax bill. Use of a life insurance trust can prevent the death benefit from being included in the estate, thereby avoiding the estate tax.

Emily S Hazlett is Vice-President:Investments at ENB Insurance Agency, Inc. a wholly owned subsidiary of Evans National Bank.

ENB Associates Inc. does not provide tax or legal advice. Be sure to consult with your own tax and legal advisors before taking any action that would have tax consequences.