One of The Last Remaining Legal Tax Shelters

One of the few remaining legal and legitimate tax shelters left is Cash Value Life Insurance. There is a minimum one can pay for a given amount of insurance coverage for a specific age. Who determines that? The insurance company, naturally.

They will tell you how much you must pay for indemnity on which they bear risk. Insurance companies and their actuaries calculate the least amount of premium they can charge and still make a profit.

But is there a maximum you can put into a cash value life insurance policy?

Yes. The government will tell you the maximum you can put into it. Why? Because of the tax advantages life insurance provides. Essentially, the government has decided the upper limit of tax-advantaged growth they will allow you to have.

That tells me that it must be a good thing, if the government regulates it. If you buy more life insurance than the limit set by the government, it becomes what is called a Modified Endowment Contract (MEC) and is no longer tax advantaged.

Before the 1980s, there were no such restrictions in place.

But, the government essentially “drew the line” with two laws: the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) and the Deficit Reduction Act of 1984 (DEFRA).

Prior to TAMRA and DEFRA, people were able to put unlimited contributions in a life insurance policy and enjoy the tax benefits that went along with it. This was counter to the wishes of Uncle Sam that Americans sink their savings dollars into tax deferred accounts, such as 401(k)s, IRAs and SEPs.

Why would the government care?

Because deferred taxes is a good thing for the tax collector. Taxes that are deferred are merely taxes postponed.

Recently, I used an illustration of a farmer opting to pay tax on the seed instead of the harvest. The government knows what it is doing when it defers taxes. The IRS is in essence offering to let you pay tax on the harvest while giving you the seed tax free.

They want your tax-deferred account to grow, just like a crop in the field, and when you withdraw the money you will be paying them more tax than you would have before.

That’s why the concept of Roth IRAs was such a welcome sight for tax savvy investors. With the Roth, you fund the account with dollars that have already been taxed and there is no more tax to be paid, ever!

Cash Value Life Insurance is like a giant Roth in that respect. The money you put into the program has already been taxed, but it grows tax-deferred and you can withdraw it tax-free.