Life insurance is vital to your financial planning if you have young children or someone who depends on your income. Most people know that life insurance helps your family if you pass away and they lose your income. But did you know that, in some cases, life insurance can also be a savings tool to help you supplement income from your retirement plan?
A life insurance retirement plan (LIRP) can help you add to your retirement savings, but it shouldn’t be the only way you save for retirement. Before you buy a policy to use as a LIRP, it’s essential to understand the benefits and drawbacks, when it makes sense to use one and how to include life insurance in your retirement planning.
What is a life insurance retirement plan?
To use life insurance as a retirement plan, your policy must be permanent life insurance with a cash value component, typically a universal or whole life policy. With permanent life insurance, the policy contract remains in effect until you die or stop making the premium payments. A term life policy, which can’t be used as a retirement plan, lasts for a set amount of time, generally between 10 and 30 years, and then expires.
Most whole-life policies have a fixed premium. In contrast, a universal policy may provide the option to adjust your death benefit and premium over time, potentially helping you save some money on your premiums as you get older.
In addition to a guaranteed death benefit and fixed premium, whole and universal life insurance also have a cash value component. When you pay premiums on a permanent life insurance policy, part of your payment goes into a savings account, which can grow tax-deferred at a set rate based on the terms of the policy.
Unlike the stock market, which may have a downturn, your whole life insurance policy usually guarantees a fixed rate. However, it’s important to note that if you have a variable universal life insurance policy, you likely won’t get a guaranteed rate of return.
This cash value will continue to grow for the life of the policy and can become a source of emergency income or a loan against the policy. Using the cash value component of your policy is how life insurance can become part of your retirement plan, although the specific rules vary by policy and insurance carrier.
How does it work?
A LIRP works based on the amount in the cash value component of your universal life insurance policy. As you make payments on the universal policy, you can pay more than the premium and direct the extra funds to the cash-value portion. Adding more money to your cash value in the first few years of the policy will likely make your money grow faster and leave you with a nice sum when you retire.
Because of how life insurance is taxed, you can borrow up to the amount you put in, called the “basis,” without paying taxes on the distribution. As the years pass and your payments and interest accumulate, the amount you can borrow will grow.
In some instances, you can also withdraw your cash value instead of borrowing against it. The terms of withdrawal will depend on your specific policy and insurance carrier. A cash-value life insurance policy generally won’t penalize you for taking a loan or withdrawing early, as long as you don’t take out more than what you put into the account.
People use life insurance for retirement planning because it provides some tax advantages—namely, it helps protect your assets from stock market volatility. You can also defer taxes on your cash-value portion. Because this is a life insurance policy, and not a retirement account, there are no income limits on who can contribute. There may also be no contribution limits depending on how your policy is written.
Using a life insurance retirement plan to help you supplement your retirement savings isn’t necessarily hard, but it can become complicated. It’s best to work with a certified financial planner and an insurance agent familiar with LIRPs to ensure this method and the policy you buy suit your circumstances.
Who is a good candidate for a LIRP?
People who benefit most from LIRPs are generally high-net-worth individuals who have maxed out their other retirement plans and want to hedge against future market downturns.
Life insurance retirement plans can also be a good way for parents and guardians of children with disabilities who will require lifelong care to ensure their child is cared for after their death.
Term policies usually make sense for most people since they likely don’t need life insurance once their children are grown. However, if you have a dependent child who will need care after your death, a whole-life policy may be worth the cost. The whole-life policy’s death benefit will provide funds to ensure a child’s long-term care.
Pros and cons
LIRPs can be extremely helpful for the right person, but there are pros and cons to consider before buying a policy.
Pros of a life insurance retirement plan
- There is no income limit, unlike most retirement plans. If you can afford the premium payment and contribute more to the cash-value component, you can use a LIRP.
- The IRS doesn’t have annual limits on how much you can contribute to life insurance for retirement. However, each policy has different rules and may limit your contributions depending on its value. However, the IRS does limit how much you can contribute to a policy over time to prevent people from using life insurance retirement plans to avoid paying taxes. If you contribute too much, your policy may become a modified endowment contract (MEC) with different tax implications.
- You likely won’t have to pay taxes on withdrawals if you don’t exceed the amount you have contributed. If the amount you withdraw exceeds the amount you’ve contributed to the cash-value portion, the excess could be taxed and may lower your death benefit.
- Whole-life policies can offer a guaranteed rate of return on your cash value. Universal policies often provide a minimum rate of return (unless you have a variable universal life policy). With this strategy, your cash value balance will grow according to your contract instead of in relation to what happens with the stock market.
- Life insurance retirement plan policies can include long-term care or disability riders for you or a dependent. An accelerated death benefit rider is an option that allows you to access your death benefit while still alive after receiving a diagnosis of a qualifying terminal illness. However, that rider ultimately reduces the death benefit your family receives, so it’s crucial to weigh your options. Also, be aware: Any riders you add can increase the premium amount significantly.
Cons of a life insurance retirement plan
- Contributions put into cash value don’t have tax benefits because this isn’t a traditional retirement plan. You fund a life insurance retirement plan with money you have already paid taxes on, like a Roth IRA. However, unlike a Roth IRA, if you withdraw more than your contributions from a whole-life policy, you will have to pay taxes on the interest.
- A universal or whole life insurance policy costs significantly more than a term life insurance policy. Because there is a guaranteed death benefit and often a guaranteed rate of return, you will wind up paying hundreds, or possibly thousands, of dollars more compared to a term policy, depending on the death benefit, how long you’ve had the policy and your overall health and age.
- You might not need it. Because the different types of retirement accounts may offer enough to support you in retirement, a life insurance retirement plan and its cash value option may not be necessary.
Bottom line
Using cash-value life insurance for retirement planning may not be the right choice for you. However, it can be worth considering if you are a high-net-worth individual who has maxed out other retirement account options. It’s best to consult a certified financial planner and a qualified insurance agent familiar with LIRPs to help determine if it’s right for your circumstances.
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