How Does Life Insurance Create Retirement Income?

We all understand that life insurance provides a death benefit, but its ability to offer additional financial resources are spectacular and often understated.  If you've researched the topic of life insurance at all, you've likely run into mention of using life insurance to create income.  Many time the discussion revolves around retirement income and this has likely raised a few questions in your mind.

How does an insurance policy provide me with income while I'm still alive?  I thought this was something that only paid when I die?

We want to answer those questions today.  We also want to discuss some nuanced but remarkable benefits of life insurance when used to create income.

Certain Types of Life Insurance can Generate Retirement Income

Only certain types of life insurance can generate income.  This is important to understand.  Term life insurance might be great for the low-cost death benefit, but it will do nothing for you if you want to create income with life insurance.

For this discussion, we are talking about whole life and universal life insurance.  When you own one of these life insurance policies, the premiums you pay accumulate cash value.  Not all of the premiums you pay go to directly to the cash value, but a portion of the premium does.

Accumulated cash values in the life insurance policy can be taken out at any time and for any reason. You don't have to die in order to use the cash value in his or her life insurance policy.

Distributions from Life Insurance Policies

You can take cash values out of a life insurance policy in two different ways.

  1. Withdraw cash from the policy
  2. Take a loan against the policy

Withdrawals from a life insurance policy mean you removed the cash from the policy.  This option is available for most life insurance contracts.  There are restrictions to withdrawals with some types of life insurance policies.

A loan does not mean you removed cash from the policy.  Instead, the insurance company lends you money.  You then pledge cash in your life insurance policy as collateral for the loan.

The method you choose to access cash in a policy depends on specific circumstances.  These circumstances include personal matters about the policyholder as well as the specific life insurance contract.

Please note: throughout the rest of this article I will use the terms withdrawal and loan very specifically.  When I use one vs. the other, I mean exactly what I outlined above.

Receive Tax-Free Income

One of the biggest touted benefits of life insurance is it's almost universal tax-free status.  Death benefits generally have no tax liability.  Monies distributed from a policy also do not usually have a tax liability.  This means you can use life insurance to generate income and pay no taxes on that income, however, that tax-free income comes with certain requirements.

You can only withdraw your cost basis from a life insurance policy without tax liability.  Here is an example to better illustrate what I'm talking about:

Let's say you have a policy where you paid $100,000 in premiums.  The policy also has $200,000 in cash value.  You can withdraw up to $100,000 from the policy without incurring a tax liability on the withdrawal.  Any withdrawal beyond the $100,000 (your cost basis) carries taxable consequences at ordinary income tax rates.  In order to access the remaining $100,000 without paying taxes on it, you can use loans.

Loans do not create any tax liability regardless of policy cost basis and gain.  This means you can use loans at any time.  The cost basis of the policy has no impact on taxability of the distribution because it took place as a loan.  There is, however, an important requirement that comes along with policy loans. The policy must remain in force in order to avoid tax liability.

Let's look at another example to add clarification:

Assume the same scenario above.  You have $200,000 in cash value where the cost basis is $100,000 (total of premiums paid up to this point).

You decide to take a $190,000 loan against the policy.  Six months later you surrender the policy.  You will receive a check from the insurance company for $10,000 (assuming the cash value balance is 10k).  This is the remaining cash after paying off the loan.

This means that you will also receive 1099  from the insurance company at the end of the year for a distribution of $100,000.  This is the gain in the policy and consequently, you must report the gain as ordinary income to the IRS upon terminating the life insurance policy.  Had you not surrendered the policy and it had remained in force, there would be no 1099 or reportable income.

Tax-Free Income Requires a Balancing Act

When we use life insurance to create retirement income, we understand that we are accepting maintaining a balance between the loan balance and cash value.  Our plan is to leave the policy loans outstanding until you die and we plan this because dying with outstanding loan balances does not create a tax liability.  A portion of the death benefit pays off the loan balance and remaining death benefit is paid to beneficiaries.

If the loan balance exceeds the cash value balance before death, we have a problem–this will cause your policy to lapse (it no longer exists). So, to add insult to injury in this scenario, not only do your beneficiaries no longer receive a death benefit when you die, you also create a sizeable tax liability.

This might sound a bit complicated but honestly, it's no more difficult than trying to figure out how much to withdraw from an investment account to ensure that you don't run out of money before dying. In fact, I'd argue it's a bit easier.

Life insurance returns tend to remain stable year over year so we need not worry about dramatic losses from market corrections.  Keeping that in mind, this makes projecting policy values and distribution amounts much simpler.

The Delightful Unintended Consequences

The “tax-free” distribution benefit of life insurance is certainly strong and hopefully, I've made that as clear as possible.  In fact, it's pretty to easy to make the argument that it's the most appealing strongest benefit of life insurance used to create income.  Just keep in mind, it's not the only great thing life insurance has going for it.

Please take a few minutes to let the following soak in: Withdrawals to basis and loans carry no income recognition for income tax calculation purposes.  This means distributions (withdrawals to basis or loans) from your life insurance policy have no affect your Modified Adjusted Gross Income, which means that taking “income” from your cash value life insurance policy creates no impact as it relates to the taxability of your Social Security Income. This is a major benefit when you get to that stage of life and gives life insurance a distinct advantage over just about every other potential income source.

Does any of this make you curious to see how a policy might work to help you create a future retirement income? If so, feel free to reach out and have a discussion with us. Typically a short conversation can determine if it's a strategy you should consider.

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