Life insurance tax benefits: A guide for high-income earners

Traditional tax-advantaged savings tools like IRAs and 401(k)s offer great tax benefits. But they also come with income and contribution caps that can limit high-income earners.

Cash value life insurance (CVLI), on the other hand, can provide a powerful solution that combines protection with long-term financial advantages.

In this article, we explore life insurance tax benefits especially relevant to high-income earners. We'll compare the main types of cash value contracts and consider scenarios where permanent life insurance can support your long-term financial goals.

Cash value life insurance is a type of permanent life insurance that combines a death benefit with a savings component. A portion of your premium goes into an account that you can access. The cash value grows over time, and you can use it during your lifetime for a variety of financial goals.

Cash value life insurance offers several tax advantages, including:

• Tax-deferred growth. The cash value inside the contract grows without being taxed annually. This tax efficiency allows your money to compound over time, with potential taxes due later upon withdrawal or policy surrender.
• Tax-free death benefit. When the insured person passes away, the insurance company pays the contract's death benefit to the beneficiaries free of federal income tax. This provides a way to pass on wealth tax-free.
• Tax-free policy loans. You can borrow against the cash value of your contract without triggering taxable income as long as the contract is structured correctly.
• No IRS contribution limits. Unlike IRAs and 401(k)s, there are no annual contribution limits for funding a CVLI contract. This feature is especially beneficial for high earners who max out their qualified retirement plans.
• Alternative to Roth IRAs. If you're not able to contribute to a Roth IRA because your income exceeds the annual limits, a properly funded CVLI contract can offer similar benefits, such as after-tax contributions, tax-deferred growth and potentially tax-free withdrawals.

Next, we'll take a closer look at the tax benefits of the most common types of cash value life insurance.

Whole life insurance offers a fixed premium, guaranteed death benefit and a predictable accumulation of cash value.

The cash value grows at a guaranteed rate and is not tied to market performance, making it a stable, tax-deferred savings vehicle. You can borrow against the cash value at any time, and the loan is generally tax-free if the contract remains in force and is not classified as a modified endowment contract (MEC).

Like anything, there are benefits and drawbacks to whole life insurance, so make sure you do your research before committing.

• Great for: High-income earners seeking more stable growth
• Factors to consider: Higher premiums, slow growth

Universal life insurance offers more flexibility than whole life insurance because you can adjust your premiums and death benefit over time.

The contract's cash value still grows tax-deferred but at a rate that can vary based on interest rates set by the insurance company. You can take tax-free loans or partial withdrawals, giving you more control over how and when you access the funds.

• Great for: People who don't want to be locked into fixed payments
• Factors to consider: More complexity and unpredictable costs

Variable universal life insurance combines the flexibility of universal life with the investment potential of market-based subaccounts.

You can allocate the cash value to investment options similar to mutual funds, allowing for greater growth potential, all on a tax-deferred basis.

As with other types of cash value life insurance, you can take out a loan against the cash value tax-free, as long as the contract isn't an MEC.

• Great for: Savers who are comfortable with market exposure
• Factors to consider: Market volatility and high management complexity

A modified endowment contract is a life insurance contract that you've overfunded by paying too much premium in too short a time. Overfunding causes the contract to lose its tax advantages.

Once a contract is classified as an MEC, the IRS treats any loans or withdrawals as taxable income, starting with policy earnings. You also might trigger a 10% early withdrawal penalty if you take money out before age 59½. This offsets the tax efficiency that makes cash value life insurance so attractive in the first place.

To avoid MEC status, the contract must pass the IRS's "seven-pay test," which limits the amount of premiums you can pay into the contract over the first seven years. Working with a knowledgeable financial advisor and tax professional can help you structure the contract correctly from the start and stay within IRS limits.

Cash value life insurance isn't right for everyone, but if you're in a high tax bracket, it could be a strategic alternative (or supplement to) other financial accounts. For example, if you've already maxed out your qualified retirement plans and are looking for ways to reduce your tax burden while building long-term wealth, cash value life insurance allows you to save more for retirement and diversify your portfolio.

Here are some common scenarios where cash value life insurance may fit nicely into your broader financial plan:

• Tax diversification. CVLI adds a nonqualified, tax-advantaged asset to a portfolio that may be too heavily weighted in pre-tax savings accounts like traditional 401(k)s and IRAs.
• Wealth transfer. Allows you to pass assets to heirs income tax-free and offset potential estate taxes with a guaranteed death benefit.
• Alternative retirement income. A life insurance loan can provide tax-free supplemental income in retirement without affecting Social Security or Medicare thresholds.
• Liquidity in estate planning. Gives beneficiaries access to cash without needing to liquidate property, investments or business interests to settle debts or taxes.

Life insurance premiums for personal policies are not tax-deductible. The IRS treats these payments as a personal expense, similar to a car payment. This means you can't deduct them on your income tax return, even if the contract includes a cash value component or is used for long-term planning.

That said, the real power of cash value life insurance isn't deductions; it's tax-deferred growth, income tax-free loans and an income tax-free death benefit. These features can support long-term financial goals more effectively than a one-time deduction.

Discuss your situation with a tax advisor to confirm your contract qualifies.

For high-income earners, traditional retirement tools often have limits that restrict their availability and ability to grow wealth. When you hit one of these walls, cash value life insurance can be a compelling alternative to support your retirement and estate planning goals. Whether you're seeking tax diversification, planning for wealth transfer or adding liquidity to your estate plan, it's worth discussing with your financial advisor how cash value life insurance might play a role in your broader strategy.

If you're interested in exploring tax strategies beyond the traditional playbook, talk to a Thrivent financial advisor. The right guidance can turn life insurance into a powerful, tax-efficient asset.