Investments that Give You the Biggest Tax Breaks (Part One)

Insurance products offer tax-deferred growth while hedging your financial risk

Investing is a wise way to build wealth for the future. But taxes can take a big bite of the money you earn if you don’t choose the right products.

Fortunately, advanced planning can put you in the driver’s seat, enabling you to make informed choices that maximize the tax efficiency of your portfolio and minimize the effect of taxes on your investments.

At the end of the day, there are two main ways to save on taxes: paying less and paying later. In this first installment of our two-part series on investments that give you the biggest tax breaks, let’s take a look at insurance products specifically designed to reap the rewards of those strategies.

Life insurance and annuities are two long-term investments with attractive tax benefits. Permanent life insurance policies can come with a cash-value component that grows over time like an investment account, and annuities typically act as a safety net that provide a steady income stream during retirement. Savings in these products are tax-deferred and create an opportunity for investors who want to hedge their financial risk.

There are several tax benefits all annuities share: the ability to control when to pay tax by timing distributions, tax-deferred growth that continues indefinitely because distributions don’t have to start at a certain age, and no contribution limits – enabling you to grow your wealth while avoiding taxes on the accumulating assets. But there are also pros and cons to each type of investment.

• Immediate annuities. Immediate annuities are long-term, tax-deferred contracts sold by insurance companies that exchange a lump-sum investment for immediate regular payments. These payments are based on your age, gender, and the amount of your purchase, and can be guaranteed to last a lifetime. As people live longer and retirements lengthen, many investors are opting to annuitize assets into reliable income they can’t outlive.

Immediate annuities sometimes get a bad rap because payments can stretch so long that you don’t recoup all your principal. But there is plenty of upside in the significant tax breaks:

• When you buy a non-qualified immediate annuity, the money you receive is divided between interest and principal. The interest is taxed as ordinary income, but the principal is tax-free because it’s a return on an initial investment made with after-tax funds. Distributions from most non-qualified annuity contracts are also subject to the 3.8 percent Medicare tax on investment income for those earning more than $200,000 a year ($250,000 for joint filers).
• If you die before you recover your principal in full, your heirs can deduct your unrecovered cost on your final tax return as a miscellaneous itemized deduction not subject to the 2 percent floor.
• Fixed annuities. A fixed annuity is an insurance contract that resembles a bank CD, but without the annual income tax that eats into your earnings. They are issued by life insurance companies to people who want guaranteed rates of return without any risk to their principal. They offer many similar benefits to immediate annuities, including lifetime income options and the ability to avoid probate delays and expense.

Another option is purchasing an equity index annuity (EIA), which is linked to a stock index. These mirror the fixed return and taxation of fixed annuities but add the chance to profit from increases in the index. Here’s the biggest tax break:

• Fixed annuities offer a tax-deferred accumulation of earnings, building interest on the principal investment, the interest, and the tax savings. Since interest is not taxed until you make withdrawals or start taking regular distributions, this triple-compounding process keeps your money working hard for you instead of Uncle Sam.
• Variable annuities. A variable annuity is a tax-deferred insurance contract that lets you choose from a selection of investments, and then pays you a level of income that’s based on their performance. In most cases there is no guaranteed return, but some new contracts offer “guaranteed withdrawal” benefits that let you draw a minimum amount without annuitizing – no matter how the market performs.

Variable annuities offer standard annuity benefits like unlimited contributions and tax-free death benefits. All gains are taxed as ordinary income, no matter how they’re earned. That means you can’t take advantage of lower tax rates on corporate dividends or long-term capital gains. But tax benefits include:

• Earnings grow tax-deferred until you withdraw them from the contract. When you do, they are taxed entirely as income until all your gains are withdrawn. Withdrawals before age 59 ½ incur a 10 percent penalty.
• You can transfer assets from one subaccount to another, tax-free. This enables you to rebalance your portfolio without paying the tax bill that would accompany similarly-styled investments, like mutual funds.
• If you lose money in a variable annuity, you can surrender the contract and deduct your loss as a miscellaneous itemized deduction, subject to the 2 percent floor.
• Permanent life insurance. If you’ve maxed out contributions to your retirement plan – and deductible retirement plans don’t fit your needs – life insurance policies that include cash value can supplement your savings with significant tax planning opportunities.

There are four main types of cash-value policies that fit different temperaments for investment:

• whole life, similar to a bank CD with required premiums and strong guarantees;
• universal life, similar to a bond with flexible premiums but the least strong guarantees;
• variable life, which lets you invest cash values in a series of subaccounts that resemble mutual funds;
• equity index policies, which guarantee a minimum fixed return with an option to profit from growth linked to a stock market index.

Participating cash-value policies pay dividends out of the insurance company’s surplus earnings that you can take in cash, leave with the insurer to earn interest, or invest in additional life insurance. No matter which option you choose, withdrawals less than or equal to what you’ve paid into the policy – known as the cash basis – are not taxable. Withdrawals greater than the cash basis are taxed as ordinary income.

There is a caveat: be careful not to stockpile too much cash into the policy in the first seven years or it will transition to a modified endowment contract (MEC), meaning it was funded with more money than is allowed under federal law. In that case, your withdrawals are taken from taxable gains before nontaxable contributions. You also incur a 10 percent penalty for withdrawals made before age 59 ½. But if you avoid triggering the MEC rule, significant tax benefits abound:

• Gains in the cash value of a permanent life insurance policy are tax-deferred – they aren’t taxed unless you surrender the policy for a cash amount that’s more than you invested. If that happens, your taxable gain equals the cash value withdrawn minus premiums paid.
• You can take cash from your policy tax-free by withdrawing your original premiums and borrowing against any remaining cash values. While you will pay non-deductible interest on the loan, you will earn it back on the cash value. That means if you pay $500,000 into your policy over the years and it grows to $1 million, you can take it all in the form of withdrawals and loans and never pay a dime in income tax as long as you maintain the policy. If you let the policy lapse, unpaid loans are taxable.
• Life insurance proceeds don’t count toward the threshold that makes your Social Security benefits taxable. They also aren’t subject to the 3.8 percent Medicare tax.

Insurance products are investment options that can offer financial peace of mind during retirement with significant tax benefits. And while other factors such as your goals, financial situation, and risk tolerance should be considered before choosing to invest in one of them, the tax-deferred growth on the underlying assets is a key selling point.

In the next installment of our two-part series on tax-saving investments, we will explore other options that offer significant tax breaks.

Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact in their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life. Contact us for expert advice on tax planning, and to find out how we can help your business exceed your expectations.