Last Money


Tax Issue

A retired taxpayer with sufficient income and assets often seeks ways to maximize the estate that will be left for heirs. The impact of taxes plays a major role in planning for the distribution of estate assets.

Applicable Tax Law

  • Gain on investment value within a permanent life insurance policy is not taxed as long as the gain is left within the policy.
  • Death benefits on a life insurance policy are generally paid to the beneficiary free from income tax.
  • If the cumulative premium payments exceed certain amounts specified under IRC section 7702A, the policy will become a Modified Endowment Contract (MEC). The death benefit of a MEC continues to be tax free. However, withdrawals or loans of cash value are taxable to the extent they exceed the basis in the policy.

Section 7702 requires life insurance contracts to include an amount of risk. The policy’s death benefit must be greater than the accumulated cash value of the policy. The ratio of death benefit to cash value is determined by section 7702.


Tax Planning Strategies

A taxpayer who has money that he or she never plans on using should consider the purchase of a life insurance policy with that money. The death benefit will pass to beneficiaries income tax free. Accumulated growth of cash value in the policy will not be taxed as long as the money is left in the policy.

Last Money. The money used to fund the insurance policy is the last money the taxpayer would ever need or use. This strategy works particularly well for retired taxpayers who have sufficient income that will continue on through retirement until death. In addition, the taxpayer should have sufficient assets that he or she can access for emergencies and opportunities. Finally, the taxpayer should be protected from unexpected liabilities, such as long term medical care needs.


Example: Ellen is age 65, retired, and a widow. She owns her home and has no debt. Ellen lives comfortably on her monthly teachers pension of $2,500 and Social Security of $1,500. In addition, she is taking distributions from her IRA to fund her annual vacations. Her IRA is valued at $200,000. She has a CD worth $50,000 and $15,000 in her savings account. Ellen also has a long-term care insurance policy with an inflation rider on it. Except for small IRA distributions or some unexpected emergency, she does not plan on using any of her savings to live on. In fact, her intention is to leave as much as possible to her children, Betsy and Tim.

Ellen’s CD is up for renewal and the rate she will receive is 1.5% for two years. Rather than renew the CD, Ellen decides to purchase a $100,000 life insurance policy. After taking the insurance exam and learning that she is in good health, Ellen deposits $50,000 into the policy. The policy’s death benefit is immediately $100,000. In addition, the cash value of the policy will increase at the market rates minus the cost to provide the insurance benefit. As long as the cash value is left in the policy, no tax will be due on any increase in the cash value.

Ellen passes away four years later. Betsy and Tim each receive $50,000 tax free from the life insurance policy. Betsy and Tim can do whatever they choose with the funds. If, instead, Ellen lives until age 90, the growth on the policy’s cash value will cause the insurance amount to increase above $100,000.

In contrast, if the money was left in CDs, Ellen would be required to pay taxes annually on the income generated. By year four, the CD value to be paid at death would no be significantly higher than the $50,000 principal amount. By age 90, the CD value could have increased much more; however, the annual tax due would decrease the true value of the account.


Possible Risks

  • Insurance policies need to be underwritten by the insurance company prior to this strategy being utilized. If the proposed insured person is in bad health, or otherwise has a short life expectancy, the internal costs of the policy may be prohibitive in keeping the policy in force for a long period of time. Only an insurance contract can guarantee an insurance amount, premiums, and costs. No values, including those used in the examples, are guaranteed by anything other than an insurance contract.
  • Variable insurance contracts are exposed to market fluctuations. A taxpayer’s risk tolerance should be evaluated thoroughly before using a variable life insurance policy.
  • Overfunding a life insurance contract (putting in an amount much larger than the premium) will often cause the policy to become a MEC. Subsequent distributions from the policy may be taxed. Withdrawals of earning by a policy owner who is under the age of 59 ½ may incur an additional 10% tax penalty.
  • Most life insurance contracts contain a contestability clause which could case the death benefits to be delayed or reduced if the insured dies within a certain period of time from the policy issue date.
  • Permanent life insurance contracts contain several expenses which can lessen the growth inside a policy. Commissions, premium taxes, insurance costs, surrender charges, and administrative costs can be prohibitive in accumulating sufficient funds to maintain the contract for several years.
  • The need for the taxpayer to withdraw money from the policy may cause the policy to lapse and therefore no longer offer the insurance that was desired.