When setting up a permanent life insurance product as a supplemental retirement strategy, it is important to know how to use the cash value. The cash value grows tax deferred and will not be taxed as long as the policy is in force. If you were to cancel your policy and take the cash value out, you would have to pay taxes on the gain above the cost basis.
When you want to use life insurance as a supplemental retirement vehicle, you want to make sure your overfund it. When I say overfund it, I mean to put money in above the premium amount. There is a ceiling that has been put in by the IRS called the MEC limit. The MEC stands for modified endowment contract and once it goes over the MEC level it no longer has the tax free treatment. The government has put a limit on the amount you can shove into a policy because of the favorable tax treatment of life insurance. Make sure to fund your policy under the MEC limit to keep the favorable tax treatment.
Once you get to a point where you want to start taking distributions from your policy, you want to start to withdraw the money from the cash value up to your cost basis. Since it is money you contributed, there is no tax on that money. Once you hit the cost basis, you should start taking policy loans as income and no tax is owed on this either. It is to be noted, that whatever money is taken out of the policy, is subtracted from the death benefit. A withdrawal can’t be paid back, but the loan can be re-paid. It is very beneficial to re-pay the loan as you are paying yourself back and a small interest charge from the insurance company.
With portfolios down 30 and 40% from a plunging stock market, it is nice to see steady growth in my permanent life insurance policy. The cash value in my dividend paying whole life insurance has a guaranteed interest rate in the cash value and it will never decline in value. While the internal rate of return may not be huge, it is good to know that it is positive every month. I will also receive the value of a dividend if it is declared by the insurance company. Usually good mutual life insurers will declare a dividend. It is not guaranteed, but if you have a policy with Mass Mutual, New York Life, Guardian, etc. they usually declare a nice dividend. A dividend is simply the return of an over collection of premium by the company. They meet their obligations and put enough away in reserves and then declare the dividend back to their policyholders.
On top of my cash value getting better every month, it grows tax deferred. When I access it I can get to it tax free through preferred policy loans. At retirement, I can use the cash value as a supplement to my retirement. First, I will withdraw money from the cash value up to my cost basis, and then use preferred policy loans. It is truly one of the most flexible and best tax shelters available. In fact, Walt Disney got cleaned out in the great depression with all of his stocks and only had his life insurance left. He took a policy loan out of his life policy to start Disneyland.
Like I said, it gets better no matter what.
