Life Insurance

With whole-life insurance (and newer variants such as universal life and variable life), a portion of a policyholder's premiums is set aside in a savings or investment account. Those funds, plus the earnings they generate, make up the cash value of the policy. Different tax advantages apply to different aspects of life insurance with a cash value. The premiums are not tax-deductible, but taxes on the "inside buildup" (earnings that accumulate within the account) are generally deferred. Death benefits are entirely tax-exempt, but withdrawals from the savings account are not--a portion of the deferred taxes on the inside buildup becomes due when funds are withdrawn. (The taxable share equals the ratio of accumulated tax-deferred earnings to the value of the account at the time of the withdrawal.)

The practice of exempting death benefits from taxes and deferring taxes on inside buildup dates to the introduction of the income tax in 1913. The only significant modifications since that time were enacted in 1984 and 1988; that legislation set a standard for how much a life insurance policy could emphasize investment over insurance. If a policy does not meet the standard, inside buildup becomes taxable as it accrues.

Although life insurance companies may not market their products as retirement savings vehicles, people may nevertheless use them as such. A retiree with little debt, financially stable dependents, and a high cash value in his or her policy may want to withdraw some of that cash to cover living expenses. Even retirees in less secure financial situations may be tempted to rely occasionally on the cash value of their life insurance. Such withdrawals, however, reduce the death benefit and may trigger surrender charges (essentially an early- withdrawal penalty) that must be paid to the insurance company. Thus, saving for retirement is generally a secondary purpose for such insurance.