This Secret IRS Loophole Lets You Reduce Your Retirement Taxes

There’s a trick amongst financial advisors that’s rarely discussed in the public, and it can reduce the tax you pay on 401(k) distributions after retirement. It’s called variable life insurance.

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Created as a way to tie the long-term investments of premium payments to a market interest rate, these policies serve as a great investment, insurance policy and tax break for the right investor.

Variable life insurance tax benefits are essentially an IRS loophole of section 7702 of the tax code. This allows you to put cash (after-tax money) into a policy that is invested in the stock market or bonds and grows tax-deferred.

The insurance policies provide a death benefit to a beneficiary but also take part of your premium and invest it in the stock market and/or bond funds for long periods of time. While that money is invested, you can switch in and out of investment subaccounts tax-free. In a regular investment account, this is not allowed.

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There is no income tax on investment income inside the policy. The thought is that you will hold the policy for 10-20 years, and if you see strong subaccount performance, you can pay the same amount each month for your premium while watching your cash value and death benefit grow.

Once the cost of insurance is covered (after x amount of years, depending on your age, health and risks), the amount of your monthly premium can be reduced while your investments still grow.

Regardless of what happens in the market, and given you have paid your premiums, your death benefit will always remain 100% tax-free to the beneficiary upon your death.

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The most beneficial element to the policyholder is tax-free retirement income. Investors need to be careful, though, as the amount you withdraw could determine whether or not there are tax implications.

As Fed Week states, you can access a portion of your cash value without owing income tax. When you want the money in your policy’s cash value, you can take tax-free withdrawals until you reach the amount of money you’ve paid in premiums, Fed Week adds.

So, say you’ve spent the past 20 years paying $500 a month, equaling $120,000 — you get all of that money back tax-free. In a normal insurance policy, this money would essentially be thrown away.

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That amount of money might not seem like a lot at first, but taken in tandem with your 401(k), it could significantly reduce your overall taxable income.

For example, whereas the money in the variable life insurance policy is tax free up to the premium amount, money you withdraw from your 401(k) will be taxed. If you are taking $1,000 a month from your variable life insurance policy, then that is $1,000 fewer dollars you need to draw from your 401(k). Since there’s no way to know what the tax rates will be in the future, this could save you considerable amount of money.

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Add in a Roth IRA that you also have been contributing to for the last decade or so, and that reduces your taxable amount even further while still allowing the investments to grow. A Roth IRA is another great investment vehicle to put post-tax money into, but unlike a variable life insurance policy, there are limits to how much can be invested.

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As Fed Week states, “The bottom line is that variable life insurance can provide tax-free retirement income to you, as long as you tap the policy carefully, and an income tax-free death benefit to your loved ones.”

There are several reasons why the government allows this. First, it incentivizes people to get life insurance, and second, that incentive will, in the long-term, reduce the financial responsibility the government will have to pay out retirement benefits. If more citizens turn to markets to rely on their retirement, all the better for a decaying Social Security system.

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The government also understands that the costs make these policies too expensive to pose any significant threat to incoming tax revenue. The average American cannot afford the roughly $500 a month initially needed to purchase these policies. The cost of insurance hovers around $200-$300, and another $200 is typically needed to make worthwhile investments.

It’s important to note that just like all other investments, suitability is paramount. Specifically with long-term investments like an annuity or life insurance, investors often do not have access to their principal for at least seven years. Normally, the policies are designed to not make financial sense unless there is at least a 10-year investment period. The prospectus provided by financial professionals will outline details, and these kinds of investments should always be purchased under the guidance of licensed advisors or brokers.

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About the Author

Georgina Tzanetos is a former financial advisor who studied post-industrial capitalist structures at New York University. She has eight years of experience with concentrations in asset management, portfolio management, private client banking, and investment research. Georgina has written for Investopedia and WallStreetMojo. 

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