Should You Use Life Insurance To Pay Tax?

A faithful Pilgrim reader posted a great question about taxes and insurance a few days ago. He’s in his mid-30’s and he is concerned about the taxes his family would have to pay on his 401k should he die. He was wondering if he should buy a universal life insurance policy in order to pick up the tax bill. I suggested that he probably didn’t need to do that. Instead, I told him to scratch this off his “to worry about “list and buy himself an extra-large orange juice to celebrate – extra pulp please. Here’s what was behind this answer:

1. Probably No Estate Tax To Be Concerned About

If our reader has a taxable estate, permanent life insurance is actually smart to consider. But very few people have to worry about that. That’s because under 2014 estate tax law, you have to have a net estate in excess of $5.34 million before the estate tax kicks in. If our reader is at that level, then universal life might indeed be a good idea. But if our reader’s estate is more modest, he doesn’t have to worry about buying permanent life insurance. Why pay to fix a problem he doesn’t have?

2. No Income Tax Problem

Our reader probably doesn’t have an income tax problem to think about either. Remember, he is 35. Like everyone else, he doesn’t know how long he’s going to live. At some point he will have to start taking mandatory distributions. (Often, 401k plans allow participants to delay distributions until age 75 as opposed to an IRA where the RMDs start at age 70 1/2.) If he lives long enough, he’ll be forced to withdraw all the proceeds of the account and pay the income tax on those distributions each year. If that’s the case, his family won’t have any tax liability on the retirement account because there won’t be one. And if the reader dies before he withdraws the entire account his family still won’t have to worry about paying income tax if they play it right. The spouse can roll over the 401k into her own IRA completely tax free. And the non-spouse beneficiaries can roll his 401k into their own inherited IRA accounts.The beneficiaries will have to take some taxable distributions immediately. But they can defer most of the tax for decades. Again, they probably won’t incur a big tax liability in any one year so there is no need for the insurance in this instance either.

3. Future Tax

Our reader is smart to be thinking about the future. I love that. But I don’t think it’s prudent for him to buy permanent life insurance out of fear that tax law might change in the future. There is no question about it; tax law will change. It changes every year. But that doesn’t necessarily mean that will be to our reader’s detriment.

It does not make sense to spend a lot of bread now fixing a problem that doesn’t exist now and one he may never have. I do believe that our reader should look into buying life insurance but I can’t see any compelling reason why that should be universal, whole life or variable life. Those policies are typically 7 to 10 times more expensive than term. For that reason, I only recommend that kind of insurance when there is a clear and present reason to do so. Are you using insurance for your future planning? How?