Most people that are asking about converting funds in their 401k over to a whole life insurance policy are looking for one thing—to convert money that will be taxable at some point (tax-deferred) over to dollars that are tax-free. You can make the conversion but not directly and not without paying taxes.
For decades, it has been common personal finance advice to put as much money as possible into your 401k, traditional IRA, or other tax-qualified retirement plans.
It seems like a really good deal, right?
A common “match” is 50% of your contributions up to 6% of your salary. Back when I had an employer-sponsored 401k, that was my deal too.
But through sites like this one and thousands of others, people have started to question the wisdom of this tactic. A lot of people are learning the hard way that maybe the gift of tax-deferral isn’t all that generous.
When you retire, at 66 (as an example) you will owe taxes on all the money that has accumulated in your 401k plan. Remember, you have not paid taxes on any of that money.
So, you will owe tax on every dollar that you withdraw from that plan.
Want to Make the Conversion? Here’s how.
There’s something that I need to explain that’s a prerequisite of sorts before we look at the pros and cons.
For most people, taking withdrawals from their 401k will require one of a couple of different things:
-You need to be at least 59.5 to avoid paying a 10% penalty tax if you are still working for the company that offered you the 401k
-Or you need to be separated from service—no longer working for the company that sponsors the 401k (the employer)
Yes, there are exceptions to these rules but for most investors, these are the two triggering events that free up the money for conversion to whole life.
The best way to understand the process of getting the funds from your 401k or IRA (both work basically the same way) is to use a real estate analogy.
Imagine that you found a foreclosed house in your neighborhood. You talk with the bank that owns the property and is able to purchase it for $100,000.
That’s a good deal because you know that after a little cleaning up, the house will sell for $130,000. After looking it over, you estimate that it will cost you about $15,000 to get it cleaned up.
You go to a wealthy friend and present the deal. He agrees to loan you the $115,000 @ 10% interest. That buys the property and gives you the cash for the cleanup.
The loan has to be repaid in 90 days.
Everything works perfectly and you sell the house on day 89 for $130,000. You owe your friend $115,000 (principal) plus the interest ($2,874).
In other words, you pay him about 20% of your profits.
This is exactly how tax-deferral works. The IRS effectively issues a note with a balloon payment that is due after you retire or when you take money out of your 401k.
Except it’s a little worse because, with your 401k, you owe the 20% on the entire amount, not just the profit or gain.
If you contributed $500,000 to your 401k over your lifetime and your total balance is $800,000, you will be taxed on the 800k, not just the 300k gain or profit.
To convert your 401k to a whole life policy, you will have to pay taxes now on any money that you take out. You can then use the balance after taxes have been paid to move into a whole life insurance policy.
When you do that, you have moved your money from a tax-deferred account into a tax-free asset. But you will have to take the haircut from taxes before the conversion is complete.
The upside is that you manage your whole life policy correctly, any money you take from it will be tax-free.
Is Whole Life a Good Way to Save for Retirement?
The answer to that question depends entirely on your expectations for your whole life policy.
If you are looking to achieve the highest returns and are comparing it to something like the S&P 500 (or other investment options), you will be disappointed. Whole life will not perform anywhere close to that.
That should not be a deterrent but instead a reality check.
On the other hand, if you view a whole life policy as a means to shield your money from the wild swings of the stock market, to have tax-free income, and to diversify into a non-correlated asset, it checks all the boxes.
After you retire, you can use the cash value in your whole life policy to generate tax-free income. Most people use it as a supplemental income source to complement social security, pensions, and income annuities.
The money that you take from your policy will not be taxed. You can take the income as a withdrawal to your basis (total premiums paid) or as a loan. Working with your financial advisor, you can decide the best option for your situation. In many cases, your best option will involve a combination of both.
Income from your whole life policy will not cause your social security income to be taxed, unlike most other retirement income sources. That is a big deal.
Think about that, the income that you take from your life insurance policy (if structured correctly by a professional) will not trigger any tax consequences. In fact, it is not even filed as an income source on your tax return.
And you will never be forced to take the required minimum distributions you would with an individual retirement account.
The biggest key to making the conversion work from a 401k to a whole life insurance policy is to allow the policy time to work. If you can do this at least a few years before needing the money, you will be better served by the policy.
Funds in a WL policy need time to grow. There is no substitute for time here. If you are looking to use a conversion like this, you will need to allow at least 7 years or longer (ideally) before using the policy as an income source for retirement.
Not that there are any restrictions on accessing your cash value prior to that but in our experience, more time for the cash value to accumulate is better for you.
Are You a Good Fit?
You should never plan on using all the money in your 401k to convert over to a permanent life insurance policy. That would not be prudent.
Here are some factors that will help you determine if the strategy makes sense for you:
Are you healthy enough to get at least a standard rating? Life insurance always requires some qualification based on your health. Remember, it pays a death benefit to your designated beneficiary when you die.
If you can qualify for a standard rate class or above, chances are the idea can work for you as the coverage will not be too expensive. Anything below standard will probably mean stunted cash value growth because of increased fees.
How much will I owe in taxes? It would serve you well to consider how much tax you will owe on the money that you want to take out of your 401k and move into your new whole life insurance policy.
Make sure that you are gaining an advantage for the conversion or at the very least understand the taxes you will owe before jumping in.
And how long you may want to fund the policy to minimize the tax hit while making the switch.
In our experience, funding a policy for 5-10 years produces the ideal result in this scenario but taking too much from your 401k could bump you into a higher tax bracket. You will need to optimize your plan to maximize your efficiency and future tax benefits.
You can convert a portion or all of the money in your 401k to whole life insurance. But you need to measure the cost of doing so to determine if it makes sense for you.
Every dollar that you take out of your 401k plan will be taxed at your ordinary income tax rate. It does not work like an IRA rollover where there are no taxes due to make the change.
The upside is that after you pay the taxes, all of the money you put into your whole life policy can provide a tax-free income to you in the future. And it is protected from the losses that you might have in the stock market. Over time you could expect to earn 2-5% depending on your age and how long you are able to leave money in your policy.