The idea of using life insurance as a retirement plan may seem, at best, counterintuitive. At worst, it sounds vaguely fraudulent if you’re not familiar with the intricacies of the life insurance industry. As far as most people are concerned, life insurance is there to support your family after you pass away, not to help you after you retire.
What if you’re the beneficiary of someone else’s policy? Could you use the death benefit you receive for retirement then? Hypothetically, yes.
However, there’s no way of knowing when someone will pass away. You shouldn’t be counting on their death to support you through retirement. You need something stable and more reliable.
Life insurance might still be the solution to your problems, but it’s going to depend a lot on your circumstances. Read on to discover if using a life insurance retirement plan (LIRP) is right for you.
You probably have or will have a life insurance policy anyway, so one that doubles as a retirement plan might seem too good to be true. In a way, it might be. Almost no one can rely solely on life insurance for retirement; you’ll still need other savings such as an individual retirement account (IRA) or 401(k).
Additionally, investing in a LIRP might not be worth it if you’re below a certain income level. Because using life insurance as a retirement plan offers the same tax advantages as an IRA or 401(k), the fact that life insurance lacks a maximum yearly investment is the main draw.
A Roth IRA limits you to contributions of $6,000 dollars a year—$7,000 if you’re over the age of 50 (2021). A 401(k) limits you to $19,500 dollars a year. Assuming you have a 401(k), that means you can invest $1,625 dollars a month in it.
The median household income of an American family is $5,264 dollars a month. Even without counting highly variable childcare expenses and student loan or credit card debt repayment, $4,140 dollars of that income is spent immediately. The average American family is left with $1,124 dollars to save for the future, use if there’s an emergency, or put toward retirement.
That’s a lot of math, but it boils down to the fact that you would have to be making significantly more than the average American family to make having a LIRP worthwhile. If you have adequate income to invest based on those calculations or a financial planner has recommended a LIRP to you, you can create one by building cash value through your life insurance policy.
Not every life insurance policy can be used as part of a retirement plan. If you’re able to do so, it will be because the policy has accumulated cash value. Accumulation occurs when the premium you pay is split three ways: your insurance company’s operating costs, your policy’s death benefit, and the cash value.
Your insurance company will invest the money you put toward your policy’s cash value, and you can expect it to grow slowly. The investment will likely be on the conservative side, meaning that it’s low-risk, low-reward, and you’ll avoid the worst of any market volatility. If you’re counting on the cash value to pay for your retirement, that’s precisely what you want.
There are two basic types of insurance that can be broken down into further subcategories. Not all of them are suitable for cash value accumulation. For the types that are, results will vary.
A term life insurance policy is one in which the insured person is only covered for a certain amount of time. If the insured person dies within that term, their beneficiary is guaranteed whatever death benefit the policy stated. If the policyholder survives and the term expires, the policy is no longer valid unless you take steps to renew it.
Term life insurance policies do not have any built-in cash value. However, they tend to be more affordable than permanent life insurance policies. That means you can put the money you aren’t spending on your insurance premiums toward another form of retirement plan.
In the personal finance industry, this concept is summarized with the well-known phrase, “buy term, invest the rest.”
Permanent life insurance can refer to any one of several different forms of life insurance, none of which expire the way term life insurance does. Permanent life insurance policies tend to be more costly than term policies. Still, they build cash value, which is what you’re looking for in a policy you’re using as a LIRP.
Whole life insurance covers the entire life of the insured person, which is where it gets its name. When the policyholder dies, their beneficiary or beneficiaries receive the agreed-upon death benefit so long as you have made the required premium payments.
While not necessary, if you want to build cash value more quickly with a whole life insurance policy, you just have to pay more than your monthly premium. This process is called overfunding, and it’s usually faster than reinvesting the dividends your current cash value generates.
Universal life insurance is generally more affordable than whole life insurance, although they’re both permanent policies. Unlike a whole life policy—the premium for which includes money for the cash value component—the premium for universal life insurance is the lowest it can be. It only covers the insurance company’s administrative costs and your death benefit.
Any money you pay toward the premium over the necessary charges goes toward the policy’s cash value. Because the cost of insurance increases as you age, some people find that putting their universal policy’s cash value toward their premium rather than using it as a retirement plan is more helpful. The flexibility that low premiums offer is useful, particularly for people whose incomes vary month to month.
Variable life insurance policies are less common than whole or universal policies because they’re more sensitive to market volatility. Like other types of permanent life insurance policies, variable policies have a cash value component. However, you will invest the cash value in sub-accounts that function like a mutual fund.
When the market is up, so is the cash value of your policy (generally). When the market is down, the cash value of your policy is down too (generally). While this presents the opportunity for significant growth when the market is doing well, many people shy away from the increased risk that a variable policy presents.
As we’ve mentioned, a LIRP has the same tax advantages as a 401(k) or IRA. When we say tax advantages, we mean that the taxes on the money you have put toward retirement have been deferred. You don’t yet have to pay taxes on the money you invest, and you might even be able to claim your investment as a deduction.
When you start taking money out of a LIRP after you have retired, you’re likely going to be in a lower tax bracket than you were at the peak of your career. That’s a good thing. You will pay far less in taxes when you defer payments than you otherwise would have.
Another concept of LIRP’s, and by far the most popular, is that you can borrow money from them 100% tax free. This is the biggest draw to using life insurance as a retirement plan. Unlimited (to an extent) contributions with tax-free distributions (as loans) is a very interesting concept that can peak a lot of people’s interest. There’s more to it than that, but that’s the point.
We’ve already talked about how there’s no maximum yearly investment for a LIRP, but that’s not the only other benefit it holds over other retirement plans. With an IRA or 401(k), you face financial penalties if you try to withdraw money before reaching the age of 59 and a half. That’s not the case with a LIRP.
There are many reasons you might find an age restriction inconvenient. Whether you’re having health problems, need the money for a family emergency, or are ready to retire and don’t want to wait, being able to access your savings without being penalized is a significant benefit.
Even if you make enough money to make having a LIRP worthwhile, there are still drawbacks that you should consider. The main issue with LIRPs—other than the fact that most of the population won’t benefit from having one—is that the return on investment may not be significant, however, there is typically downside protection as well (and, of course, tax-free loans).
While there aren’t age restrictions surrounding your ability to withdraw money from a LIRP, your insurer may decide to charge a fee on the withdrawal. That can quickly become irritating and expensive, so choose your life insurance provider carefully.
Luckily, you’re not stuck navigating the complexities of life insurance and retirement alone. NextGen Wealth offers expert advice to ensure you’re making the best possible plans for your future. Sign up for a free 15-minute consultation today!
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