Many potential buyers think that the only purpose of life insurance is the death benefit. While that is its main function, there are also plenty of other benefits – some insurance policies can even help supplement your retirement income.
So, what is an insurance retirement plan? How can you use life insurance as part of your retirement strategy? And is it better than traditional retirement savings accounts? Keep reading to find out!
What Are Life Insurance Retirement Plans?
Also known as an LIRP, a life insurance retirement plan aims to fund your retirement using life insurance products. This is done through the cash value component of certain types of policies, which functions like a savings account. The cash value grows over time and can eventually be withdrawn from tax-free before reaching age 65.
Take note that only permanent life insurance plans (e.g. whole life, universal life, etc.) allow you to build cash value. Term life insurance and other short-term insurance options do not have this component, so they can’t be used as an LIRP.
What Is Cash Value And How Does It Work?
Life insurance is a contract between the insurer and a policyholder, wherein the insurance company promises to pay a designated beneficiary a sum of money (death benefit) in exchange for monthly payments (premiums).
With permanent policies, a portion of the premiums you pay goes into a tax-deferred savings account known as the cash value of the policy. This cash value can grow, earn interest, and even be used as emergency funds. You can withdraw from it or take out policy loans against it, providing you with tax-free income after you retire.
The rate at which your cash value grows usually depends on the policy you get as well as the insurance company you choose. Unlike 401(k)s, LIRPs have a set growth rate – cash value growth is not based on the performance of the stock market. This is a great option for investors who want to grow retirement funds without having to worry about market volatility.
In years where the market is down, it might be better to withdraw your retirement income from your life insurance retirement plan. Growth isn’t affected by the declining stock market and your withdrawals will be income-tax-free.
Pros And Cons
A life insurance retirement plan offers you a lot of financial flexibility down the road, but it definitely isn’t for everybody. You should understand its pros and cons before incorporating it into your long-term retirement plan.
Much like a Roth IRA or 401(k), the main draw of investing in a LIRP is that the income you earn from it is tax-deferred. This means the money you invest in the cash value account will grow tax-free – it will only be considered taxable income when you withdraw it.
An LIRP also guarantees a minimum return as long as the policy is maintained. Regularly making your premium payments build your cash value. You’re essentially hitting two birds with one stone by paying for insurance and securing your retirement income. Plus, there’s a set growth rate, so you know exactly how much your account will grow year over year.
Lastly, a LIRP is less restrictive when it comes to depositing to or withdrawing from the savings account. Traditional retirement accounts like IRAs or 401(k)s are capped at a certain amount for deposits, but there is no limit to the amount of money you can put in a LIRP. There’s also no penalty for accessing your LIRP funds before the age of 59 ½.
The main drawback is that an LIRP will not provide comparable retirement income returns to IRAs or 401(k)s. A LIRP is often used as a supplement, not a replacement, of traditional retirement accounts.
We’d recommend investing in an LIRP if:
You have already maxed out your contributions to your other investments.
It’s a bad stock market period and you want a safer avenue to grow money.
Additionally, many insurance agencies will charge administrative fees on cash value withdrawals. The fee varies among insurance policies, so discuss the specific figures with your life insurance agents beforehand.
Remember that life insurance is still the main product you are paying for, not the savings component. Permanent insurance can get expensive to maintain in the long run, so you will need to carefully weigh the options if you’re thinking of investing in a LIRP.
Can You Overfund Your Whole Life Insurance Policy?
People who want to build cash value quicker may pay more than the premium rate, so that the extra money goes into their retirement savings. Just be aware that there is a limit on how much you can fund your policy before it gets re-classified into a modified endowment contract.
A modified endowment contract (MEC) is a tax qualification that is applied to life insurance policies that have been funded beyond the federal tax limits. You reach this status when the total amount of premiums paid into the policy for the first seven years is more than what was required in that time frame.
Keep in mind that this isn’t necessarily a bad thing, it just means your policy will have a new set of rules that you have to be aware of. If your policy falls under this category, any withdrawals before you reach 59 ½ years old are subject to a 10% penalty fee. Furthermore, withdrawals and loans from your policy will be taxed as regular income.
The cost basis (sum of all insurance payments) and death benefit are still not taxed when you have an MEC. This makes it a good option for long-term financial goals (and estate planning preparations), provided you do not withdraw from it prematurely.
Who Should Get A Life Insurance Retirement Plan?
If you already have a whole life policy, then building the cash value for retirement is an excellent way to get the most out of the policy. However, keep in mind that your built-up cash value might not be enough to fund your retirement entirely. It’s better to use it to supplement your income stream once you retire.
That being said, this financial planning strategy is definitely not for everyone. Monthly premiums can get expensive very quickly, and not everyone needs insurance after reaching age 65. By this time, you should have fewer financial responsibilities, especially if you’ve paid off your debts and have been hitting your financial goals.
So, who benefits the most from a life insurance retirement plan?
High-income earners who have already maxed out their yearly contribution limits on their retirement accounts can make the most of LIRPs by utilizing them as an extra avenue for tax-deferred savings.
Individuals who have lifelong dependents and need the financial protection of permanent death benefits can also utilize the cash value component to help save money for retirement.
Basically, if you need permanent insurance because you have loved ones who will be dependent on that money in the event that you die, then it makes sense to keep investing in a permanent insurance policy. The cash value component is just an added extra feature that you can maximize to help you out later on in life. Otherwise, only invest in a permanent life insurance policy if you have no options left for income-tax-free investment opportunities.
Is A Life Insurance Retirement Plan Worth It?
The short answer? Yes, but only for a specific group of investors. The truth is that the majority of workers will not need insurance once most of their financial responsibilities have been satisfied. Plus, permanent life policies are expensive and can become difficult to maintain.
The cheaper option for those who only need insurance up until a certain point is to just purchase and maintain a term policy until they don’t need it anymore. Term policies are much cheaper, and the income you save from buying a cheaper policy can be diverted into a dedicated retirement fund like a 401(k) or Roth IRA. These retirement funds should be your primary source of income during retirement anyway.
However, if you need permanent insurance or consistently max out your retirement fund contributions per year, then LIRP can be a great retirement planning tool.
Life insurance policies are useful not just because of the death benefit, but also for retirement planning. The cash value you earn as part of a permanent life insurance policy can serve as an alternative source of tax-free income once you retire. If you have extra funds and want to avoid post-tax investment accounts, LIRP is a great option.
If you need help with your retirement plan, Wesley Insurance, LLC is here for you! We specialize in all things investment, insurance, and tax – contact us today to learn about what we can do for you.