Tax Diversification with Life Insurance - Milestone Wealth Management
Life insurance and tax diversification

Tax Diversification with Life Insurance

When most people think about life insurance, what typically comes to mind is the death benefit. And secondly, how much will I need to pay for a given amount of coverage?

What few people realize, however, is that there are certain types of life insurance policies that offer some great living benefits as well. You see, if the right kind of policy is designed well and properly funded, the cash values can grow tax-deferred. And when done correctly, these cash values can be accessed tax-free.

Surprisingly, there’s nothing difficult about setting this up. All you really need to know is whether or not this kind of policy is right for you?

I’ll start by saying that if you’re over the age of 60, it probably wouldn’t make sense to begin incorporating this strategy into your planning now. However, if you’re under 60 years of age, this could be worth looking into.

Why? Well, let’s take a step back for a moment and consider this question…

Do you believe that income taxes will likely be higher or lower in the future?

Our national debt is nearing $20 trillion and there’s no end in sight to the spending. Sooner or later, somebody has to start paying this debt down. So, if you were to ask, I don’t think the question is at all about whether or not taxes will increase – I believe the question is when will taxes increase and by how much?

And for people under the age of 60, these kinds of life insurance policies could provide the advantage of tax diversification later in retirement.


Let’s talk about tax diversification.

This is an important but often overlooked principle when it comes to retirement planning. Sure, most people understand what it means to diversify our investments. But too few people really understand what it means to be “tax diversified” and how it can affect retirement. In fact, the vast majority of people I meet have no tax diversification at all.

For example, most people enter retirement with a 401(k), 403(b), 457 plan, or an IRA. These are all great tools. When we funded those plans, we received a tax deduction on our contributions. And who doesn’t like that, right?

However, if those are the only kinds of plans we are carrying into retirement with us, there could be some problems. When we begin using those funds for income, we now have to pay taxes on every dollar distributed. And I’m talking about income tax rates – not the lower capital gains taxes. This taxable income could cause your Social Security benefits to be taxed, or even increase your Medicare Part B premiums.

We can reduce our tax liabilities in retirement by diversifying the kinds of savings and investments in our portfolio. This means including plans that not only allow your money to grow tax-deferred, but also allow you to access that money tax-free.

For people under the age of 60, this is a critical strategy for minimizing the retirement tax burden and hedging against future tax hikes.

Let me share a very simplified example here to illustrate what I mean by tax diversification. Let’s say you’ve entered retirement and wish to withdraw $80,000 from your portfolio every year. If that money is coming only from plans like a 401(k) or IRA, then the IRS will look at your $80,000 as fully taxable income.

On the other hand, let’s say you’ll withdraw $40,000 from a 401(k), for example, and another $40,000 from a tax-free plan. Now, the IRS is only considering $40,000 as your taxable income. Not only will you be paying less taxes, you could end up in a lower marginal tax bracket, too. And that means your effective tax rate might be less!

One takeaway point here is that how much you’ve accumulated going into retirement isn’t necessarily as important as how much spendable income you will receive.


Again, I really want to emphasize that this strategy typically works best for people who start it before the age of 60.

Now, most people are already familiar with a Roth IRA. And a Roth IRA is a fantastic tool. But one of the biggest frustrations many people have with the Roth is its low contribution limits. Currently, you’re limited to contributing $5,500 per year, or $6,500 per year if you’re aged 50 years or older.

The other big issue people have with the Roth IRA is the income restriction. If you make too much money, you can’t contribute at all.

This is where the specific types of life insurance policies I’m talking about can really make a difference. If you’re in a position where you could contribute $10,000, $20,000, or perhaps even $100,000 or more per year, these policies can allow you to do just that. And, when it’s done correctly, you get to enjoy all tax benefits I mentioned.

Okay. Is this strategy right for everyone? Absolutely not! But for many people this kind of strategy as a part of their overall plan can make a lot of sense by potentially reducing their taxes and increasing their overall retirement income.