Should you consider using a life insurance policy to create retirement income that could be tax free?

The Life Insurance Retirement Plan

The life insurance retirement plan isn't necessarily a specific “plan” that accomplishes a specific goal related to retirement planning. Instead, it's a “tip of the hat” to the fact that life insurance will accommodate strategies that focus on retirement income.

It does this because of the versatility that cash value life insurance provides.

The idea of a life insurance retirement plan gains popularity with each passing day as people seek out alternatives to hedge more traditional approaches to retirement planning.  That's not to say that the more traditional ideas are wrong.

I certainly do not mean to suggest such. Instead, the use of life insurance for retirement preparedness works as a complement to absorb the vulnerabilities investment strategies like passive index investing possess.

Life Insurance is about Dying not Retiring

The notion of a life insurance retirement plan appears paradoxical for a lot of people.  Tell them they should buy life insurance to prepare for retirement and a significant number of them will raise palm to your face and declare “I'm not planning to die, I'm planning to retire.”

This confusion starts with the general idea of what insurance is.

Essentially a contract promising the payment of some benefit should a specific event occur in exchange for the collection of premiums paid by the insurance contract owner.  Premiums are an expense.

Insurance is an expense.  Therefore, life insurance does not help prepare for retirement unless the plan is to die and leave your spouse with lots of money to fund retirement.

But that understanding of life insurance is narrow and only encompasses a fraction of what life insurance can actually do.  Those who remain stuck in this narrow understanding miss out the opportunity life insurance can and does unlock for hundreds of thousands of people every year.

Cash Value Life Insurance: a Key to the Life Insurance Retirement Plan

Some, but not all, life insurance policies accumulate cash value.

The accumulation of this cash value is a result of the capitalization life insurers need to support the liability the insured under the contract poses to the insurance company.  This liability is simply an outstanding death benefit.

All life insurance contracts have a minimum amount of money the insurance company must collect to cover expenses and build some level of reserve to address the death benefit liability.  Most of these same life insurance contracts also permit the policy owner to give the insurance company additional funds that go directly to the same cash reserve.

You might suspect that since the insurance company uses premiums to build a reserve that covers the likely need to provide a death benefit to any given policyholder, it has a motivation to create the highest return on those collected premiums it can without risking significant losses on the money.

There's a balance that each asset manager at every life insurance company must maintain: create as good a return as possible without also subjecting the pot of money to substantial losses if economic conditions turn south.  Life insurers excel at this investment strategy.

Added Bonus

The life insurance company's goal to achieve a high return on the money it collects comes with a twist that is beneficial to you and I should we choose to buy life insurance and give the life insurance company more money than it needs to reserve against our death benefit.

There is no mechanism in place that permits the insurance company to separate the funds it absolutely needs from the ones it receives electively from the policy owner.  This means the life insurance company will seek the same return on cash regardless of its necessity to your policy.

They will work just as hard to produce a stable rate of return on the dollars it doesn't necessarily need as the ones it requires the policy owner to pay.

Life Insurance Investment Return Example

Marie buys a blended whole life insurance policy with a base premium she must pay of $5,000 annual.  Additionally, Marie can choose to pay an additional $15,000 annually to the policy through a paid-up additions rider.  Marie decides to make payments maximizing this feature to the life insurance company for a total annual amount of $20,000.

With each $20,000 payment, the life insurance company will seek out the same return on the $15,000 payment as it makes the $5,000 payment.  While the insurance company doesn't need all of the cash that the additional $15,000 payment creates, it does help Marie build additional cash value in her policy that she can use for whatever purpose she sees fit.

So instead of being a purchase about the selflessness of providing for loved ones if you die, the life insurance retirement plan highlights a slightly selfish aspect of life insurance used for the intentional build-up of its cash value.

To be sure, there's still a death benefit, and that death benefit can take care of your loved ones should you die prematurely.  The death benefit could also act as a mechanism to recharge your retirement or legacy planning upon death because the types of life insurance policies used in this case never go away.

The Four Key Reasons you Want a Life Insurance Retirement Plan

While the benefits of life insurance used as part of your strategy to prepare for retirement are many, I want to highlight the top four that are the most compelling.  These four attributes make a strong case for life insurance as part of your retirement plan, and they include:

  1. Tax efficiency
  2. Funding Flexibility
  3. Distribution Flexibility
  4. Leverage

You'll likely realize without my needing to point it out that these four features are powerful on their own, but they work synergistically to augment each other.  The old aphorism the whole is greater than the sum of its parts applies.

Tax Efficiency of the Life Insurance Retirement Plan

Life insurance enjoys incredible tax efficiency.  Most of us understand that the death benefit is income tax-free, but that's just a sliver of the tax-free nature of life insurance.

The cash value inside a life insurance policy builds tax-deferred.  This means with each increase in your cash value, you will not receive a 1099 in the same way you receive one for interest paid each year by your regular savings account or a CD.

Additionally, the turnover of the insurance company's investments or income produced by those investments does not pass to the policy owner like it would with a mutual fund.  Instead, the cash value grows year-over-year with zero taxes due by the policy owner.

The money that you take out of a life insurance policy can also avoid tax implications.  Withdrawing money first takes cash from the contributions you already made, which are not taxable (we call this the First-In-First-Out accounting principle).

Loans, the other way one accesses his/her cash in a life insurance policy, have no income tax liability because U.S. tax codes treat them as loans.  You don't owe any taxes on a home equity loan, and you don't owe any taxes on a life insurance loan provided the policy remains in force.

This means you can extract nearly all the cash value housed inside a life insurance policy without ever paying taxes on the growth produced by the insurance company's investment activity.

On top of this, if you keep the policy until your death, all of the remaining value of your policy pays out in the form of the income tax-free death benefit to your beneficiary(ies).  You indeed can avoid ever paying taxes on the cash created by a life insurance policy.

This alone is a powerful feature of life insurance, but the tax efficiency of life insurance doesn't stop there.

If you own a whole life insurance policy, dividends paid by the life insurance company enjoy the special treatment as a refund of the premiums you already paid to the life insurance company.  This makes dividend payments non-taxable to you.

You can then return those dividends to the whole life policy contributing them to the cash build-up of the policy and turn that tax free dividend into growing tax free cash value.

Lastly, distributions from a life insurance policy do not affect provisional income calculation.  This is the income the IRS uses to determine if you owe taxes on your Social Security income.

So unlike distributions from a standard IRA or 401(k), which can cause a tax liability on your Social Security income, taking money from life insurance does not cause you to owe taxes on your Social Security income.  You can pull as much money as you want from life insurance without a worry in this regard.

Funding Flexibility of the Life Insurance Retirement Plan

As of 2019, you can contribute up to $6,000 per year towards an IRA with a provision to add an additional $1,000 if you are 50 or older.  For 401(k) et al. participants, you can contribute up to $19,000 and receive a tax deduction on the contribution with a provision to add an additional $6,000 if you are age 50 or older.

Life insurance does not have a specific annual funding limit.  You can, within reason, contribute as much as you want to a life insurance retirement plan.  I say within reason because a more significant contribution will create a more substantial death benefit on the life insurance policy and you will need to justify the amount of life insurance put in place.

It's rare that someone wishes to make contributions to a life insurance policy that goes beyond the bounds of what a life insurance company will allow, and these limits are considerably higher than accounts like IRA's or 401(k)'s.

To highlight the power this creates, consider a real-life example we published years ago from someone who shared his results saving money in a whole life insurance policy.  The annual contributions go way beyond the permitted limits that existed for IRA's when the plan originates in the early '90s.  It would have been impossible for him to create the same tax-free pot of money with a Roth IRA due to funding limitations.

Distribution Flexibility of the Life Insurance Retirement Plan

Unlike most retirement savings plans that assess a penalty for distributions occurring before the saver's age 59.5, you can take distributions from life insurance whenever you want penalty free.  This makes life insurance very useful if an emergency or suitable investment should come along.

This also makes life insurance an excellent option for people that are hyper-focused on “early” retirement.  There's no need to take distributions in any systematic fashion like a 72t distribution from a qualified retirement account.  You can take as much money as you want in different amounts year-over-year if you wish.

Also, life insurance won't force you to take distributions at age 70.5 as qualified retirement accounts do through required minimum distributions.  If you choose to keep the money right where it is growing tax-free until age 80, that's totally your choice, and nothing can stop you from doing it.

Leverage and the Life Insurance Retirement Plan

Life insurance has a lot of nifty features, but one of the niftiest is the ability to take a loan out against the policy.  Doing this, allows you to access the value of your cash stored in the policy, while still earning a return on the money.

I'll explain this in more detail with an example.

Leveraging the Life Insurance Loan

Phil owns an indexed universal life insurance policy with $500,000 of cash value.  He chooses to take a loan against the policy for $25,000.  The loan he chooses allows him to continue to earn the index credits he normally earns on both the $25,000 that supports his loan an the remaining unencumbered $475,000.

While Phil will incur an interest charge of 6% annually on his $25,000 loan, he earns interest up to 10% each year on his $500,000 of cash value.  This means Phil's cash value will grow at a much faster absolute rate, even if he only earns 1% on his cash value than his outstanding loan will.

There are many applications for this feature of life insurance.  It can help someone take a loan to invest in a chance opportunity without losing the growth track he/she is on for retirement.  It can work as a way to pay for major expenses like college with the ability to pay off the loans and come out ahead of starting a new savings plan after college is over.  It can also produce more retirement income than a similar savings balance in other investments.

The leverage feature of life insurance is compelling when it comes to delivering real value and buying power to a policy owner, and it's undoubtedly a significant feature of any life insurance retirement plan.

Should You Buy Life Insurance for Your Retirement?

Life insurance possesses a diverse and unique set of benefits for retirement planning.  It's a great complement to most plans, and a lot of people can certainly benefit from taking the time to learn more about it.

However, the idea isn't for everyone, and I want to note some broad examples of where it likely doesn't apply.

First and foremost it is life insurance, and you have to be insurable.  If you have a health or lifestyle element that precludes you from favorable life insurance underwriting, this isn't going to work.  While some suggest you simply look for someone else to use as the insured, this is easier said than done.

Life insurance companies don't love the idea of you buying life insurance on someone else for any old reason so they have a short list of permissible reasons they'll allow it.  What's more, a lot of people assume they can just use a child or grandchild as the insured because their younger and healthier so they'll likely receive excellent insurance rates.

While that last thought is usually correct, life insurers will need a considerable explanation regarding your insurable interest when seeking to buy life insurance on someone upon whom you likely have little to no dependency from an income earnings point of view.

Secondly, this is not an excellent idea for someone with just a few years left before retirement.  Life insurance becomes incredibly efficient at creating cash value growth over time, but it requires a handful or more years to overcome initial expenses.

If you plan to begin using the cash value for income within the first five years of the policy, your life insurance policy will never have a chance to reach its true potential as cash value growth machine, and there are very likely other options that will deliver more value to you.

Lastly, you should have a baseline of financial affairs in order before you embark on establishing a life insurance retirement plan.  While this isn't always a hardline knock out like the other two, you considerably raise the risk that some unforeseen financial event leaves you susceptible to having to cancel your policy because you over-committed yourself on financial obligations.

If you're deeply indebted, have no emergency savings account, or are in a transitional employment period you might want to hold off on tackling setting up life insurance for retirement planning.  There are other financial obligations you should first address.

Beyond these situations, looking into a life insurance retirement plan could prove useful.  There is a good chance that it will introduce you to a whole new world of financial security that provides more significant wealth building benefit and peace of mind when it comes to retirement planning.

About the Author Brandon Roberts

Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. A specialist in the design and application of life insurance cash accumulation features, Brandon is one of the foremost authorities on the subject of coordinating life insurance cash values in a financial plan.

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