5 tax-smart ways to invest a life insurance payout
You just found out that your long-lost great uncle died … and he left you as beneficiary on his life insurance policy.
The money isn’t enough to storm your boss’s office to quit, but it’s too much to blow on a new wardrobe and a tropical vacation.
So what are your options?
That's essentially what Lupe, an Interest.com reader, asked in a comment she left on a recent story.
Her question was passed on to me because I frequently deal with issues like this in my law practice.
First, you should know that, generally speaking, you won’t owe income taxes on your life insurance proceeds.
This same rule applies to most inheritances.
In other words, if you inherit money or property, you typically don’t treat what you receive as income. (The big exception to this is inheriting a 401(k) plan or Individual Retirement Account.)
Here are some tax-focused ideas for investing your windfall:
- Maximize your traditional 401(k) contribution. If you don’t fully fund your 401(k) at work each year because of a budget shortfall, you’re leaving a tax deduction on the table. You could use your tax-free inheritance to fill the hole in your budget and fully contribute to your 401(k) ($17,000 for 2012) which will give you a tax deduction. This should also ensure that you maximize your employer's matching contribution.
- Open a traditional or Roth IRA. Same idea here as with the 401(k), only the contribution limits for a traditional or Roth IRA are less ($5,000 for 2012). Also, if you are covered by a 401(k) or other retirement plan at work, then you likely cannot deduct your traditional IRA contributions from your income.
- Buy cash-value life insurance or annuities. Both of these types of assets are tax-deferred. This means that the cash value builds up over time and you don’t pay tax until you pull the money out.
- Invest in rental real estate. Real estate prices and loan rates are at historic lows. You might find a property that gives you positive cash flow and a tax loss at the same time. Favorable tax laws will allow you to deduct at least a portion of the tax loss from your regular income.
- Buy growth stocks or municipal bonds. These assets are widely available. Growth stocks will grow in value while not paying much in the way of dividends. Municipal bonds will pay interest that's not subject to federal income tax. In both cases, you’ll receive economic benefits without owing much, or any, tax.
You should talk with your investment and tax advisers about your individual situation to determine if any of these strategies are advisable for you.
Clint Costa is an attorney and CPA at the law firm of Shaheen, Novoselsky, Staat & Filipowski in Chicago.