Setting money aside for the future is important. The federal government feels it's so important, in fact, that it’ll pass on the taxes it could be taking on certain accounts. Qualified retirement plans, like Individual Retirement Accounts (IRAs), grow tax-deferred and may even offer a tax deduction for deposits. Like preparing for retirement, preparing for an unexpected death is important enough that the IRS allows life insurance cash value to grow tax-deferred. Understanding the differences between the money in an IRA and the money in a life insurance policy can help you plan for the future.
Most often people have IRAs consisting of mutual funds, stocks, bonds or other equities. Some people have annuities that are structured as IRAs, while others may even have savings accounts or certificates of deposit at their local banks that are IRAs. Unlike an IRA balance, the cash value of a life insurance contract does not change based on the amount of premium you pay in. Instead, the guaranteed cash value of the contract grows at a set rate.
Traditional IRAs allow you to deposit money pre-tax (through a tax deduction you claim on your return), requiring you to pay income tax on the entire amount that you take out. Roth IRAs do just the opposite, taking after-tax money (not offering a tax deduction) so the payout is tax-free. Life insurance is always paid after-tax so that any death benefit is paid tax-free. If you surrender a policy for its cash value, any gain will be taxed.
The IRS provides a way for you to move tax-deferred funds from one account to another without getting hit by a tax penalty. Money in an IRA is treated differently than life insurance cash value under this provision of the tax code. While you can transfer from most retirement plans -- such as a 401(k), 403(b) or another IRA -- into an IRA without penalty, you cannot transfer an IRA into a life insurance policy. Life insurance cash value, on the other hand, can be transferred into an IRA. You can also transfer cash value from an existing life insurance policy into a new one.
When you want to get your money out to spend it, then the IRS wants its cut. If your money is in an IRA, you have extra rules about taking your money out. The IRS levees a 10-percent tax penalty on money withdrawn before age 59 1/2, and if you're over 70 1/2, you're required to withdraw a set amount each year. Life insurance cash value, on the other hand, won’t hit you with any additional tax penalties, and can stay in the policy until you die. If you take cash value out of the policy, you may forfeit some or all of the death benefit, as well as increasing your taxable income for the year.
Sean Butner has been writing news articles, blog entries and feature pieces since 2005. His articles have appeared on the cover of "The Richland Sandstorm" and "The Palimpsest Files." He is completing graduate coursework in accounting through Texas A&M University-Commerce. He currently advises families on their insurance and financial planning needs.