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.