You can use a cash value whole life insurance policy to supplement your retirement income, but this strategy comes with a few risks. Learn how a life insurance retirement plan (LIRP) compares to a 401(k) and IRA.
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byPatrick Hanzel, CFP®
Patrick Hanzel, CFP®
CERTIFIED FINANCIAL PLANNER™ & Advanced Planning Team Lead
Updated April 21, 2021|5 min read
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If you own a whole life insurance policy — or any other type of cash value life insurance — you can use your life insurance policy’s cash value to supplement your retirement income. This is known as a life insurance retirement plan or a LIRP.
Some insurance agents tout LIRPs as a major advantage of cash value life insurance. But while cash value policies sometimes offer flexibility and tax advantages in retirement financial planning, using life insurance to fund retirement savings comes with risks that all life insurance shoppers — particularly those approaching retirement — should know about.
Read on to see whether buying this type of insurance makes sense for your retirement strategy and how cash value life insurance stacks up against a 401(k) or individual retirement account (IRA).
A life insurance retirement plan (LIRP) is a cash value life insurance policy that’s used to supplement other retirement funds (such as 401(k) and IRA accounts)
Because LIRPs are expensive, they are usually only beneficial for high net worth individuals
Term life insurance, which doesn’t have a cash value component, cannot be used for a life insurance retirement plan
A life insurance retirement plan (LIRP) is a permanent life insurance policy that uses the cash value component to help fund retirement. LIRPs mimic the tax benefits of a Roth IRA, meaning you don’t pay taxes on any withdrawals after you are 59 ½ years old and cash gains are tax-deferred. Any permanent life insurance policy with a cash value, such as whole life insurance, can help fund retirement. Term life insurance, which lacks a cash value component, cannot be used for a life insurance retirement plan.
A certain percentage of your cash value life insurance policy’s premium payment goes into a tax-deferred, investment-like savings component, known as the cash value of the policy. The exact amount that goes into savings is determined by your individual policy and the cash value account grows over time.
After you’ve held the cash value for long enough, or after it accumulates a certain amount, you can access the money by withdrawing from it or taking out a loan against it, and that money can be used to provide tax-free income in retirement.
LIRPs can bolster your existing retirement savings accounts and fill in the gaps if there’s a stock market downturn. If you max out contributions to your traditional investment accounts, you can pay any extra funds into your cash value, creating an additional avenue for tax-deferred investment growth. In a down year for the stock market it might be more beneficial to pull from a cash value with a set rate of growth than from a retirement account with a depreciated value.
To build up enough cash value to supplement retirement, some policyholders choose to overfund their cash value life insurance policies by paying well over the required premium each month. The extra money they pay goes into the policy’s cash value and grows tax-deferred. But this strategy only works if you don’t need to make withdrawals before age 59 ½: An overfunded cash value policy that exceeds the annual premium limit (set by the IRS) converts into a modified endowment contract (MEC) and is subject to additional taxes and penalties for withdrawals.
Many financial experts recommend the “4% rule,” withdrawing no more than 4% of your savings in each year of your retirement. When you own a cash value life insurance policy, you’ll have access to your policy’s cash value in addition to your retirement accounts.
This allows you to be strategic about your retirement spending. For example, after a down year in the stock market, you can withdraw money from your policy’s cash value instead of drawing down from your IRA, which will replenish your IRA savings.
Most life insurance policies, including cash value policies, have the option to add on a long-term care rider. This rider provides an accelerated death benefit as you age, if you need to pay for a nursing home, or have other medical costs associated with aging.
Most people won’t need life insurance at all by the time they retire. That’s because as you get older, your financial obligations — such as paying off a mortgage or supporting dependents — usually decrease and so does your need for life insurance.
But using a cash value policy to supplement retirement income can make sense for people with more complex financial needs or people who know they’ll need life insurance coverage for the rest of their lives. These include:
High net worth individuals who have already maxed out other retirement accounts and are seeking an additional vehicle for tax-deferred savings.
People with lifelong dependents, such as children with disabilities, who will still need life insurance coverage when they’re retired.
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The premiums for your permanent life insurance policy go toward investing in your LIRP, and you can choose to add additional funds to that amount. It costs more to buy permanent life insurance than term life; whole life insurance premiums are five to 15 times higher, on average. If affordability is what you’re after, then buying a term policy and investing the money you save from not buying a whole life policy makes more sense than funding a LIRP.
|TERM & 401(k)||TERM & ROTH IRA||PERMANENT & LIRP|
|Monthly premiums||$25.43||$25.43||$127.15-$381.45 (5-15x term)|
|Cost of retirement account||No minimum investment required||No minimum investment required, some brokers set a minimum initial investment||Cost of policy premiums|
|Maximum investment per year||$19,500 (+$6,500 if older than 50)||$6,000 (below age 50); $7,000 (age 50 & up)||None|
Regardless of which kind of life insurance policy you decide to buy, dedicated retirement accounts such as a 401(k) or an IRA should still be the primary way you fund your retirement. Cash value life insurance has limited investment options and relatively low rates of return compared to dedicated retirement investment options.
A 401(k) is a retirement savings plan that employers offer to employees. Many employers also match a certain percentage of employees’ contributions to their 401(k)s.
An IRA is a retirement savings plan that you open and fund on your own. IRAs can be used alone or in addition to an employer-sponsored 401(k).
|LIRP (cash value life insurance)||Traditional 401(k)||Roth IRA|
|Contribution limits||Varies by insurer||$19,500 (+$6,500 if older than 50)||$6,000 ($7,000 if older than 50)|
|How you contribute||Premiums (after-tax dollars)||Pre-tax income||After-tax dollars with no tax deductions|
|How your money grows||Tax-deferred||Tax-deferred||Tax-free|
|(Penalty-free) withdrawal qualifications||59½ years old and up and an account at least 15 years-old||59½ years old and up||59½ years old and up and an account at least five years-old|
|Withdrawal taxes||Only if your withdrawal exceed cash value base amount||Taxed as regular income||No income taxes|
|Required minimum distributions||Varies by policy premiums||70½ years old and up||None|
|Capital gains tax||Yes||Yes||No|
In some circumstances, a life insurance retirement plan can offer additional flexibility, but there are several reasons why relying on cash value life insurance for retirement isn’t recommended for most people.
|PROS OF LIRPS||CONS OF LIRPS|
|Guaranteed death benefit when you die||Expensive premiums that can be difficult to maintain long-term|
|Penalty free access to cash value (if borrowing and not withdrawing)||Additional fees for withdrawals depending on how long you've held the policy|
|No contribution limits||Lower investment returns than a 401(k) or IRA|
|Tax-deferred cash value||Cash value loans accrue interest until repayment (the loan plus interest is deducted from your death benefit when you die)|
|Guaranteed minimum||Contributions are not tax-deductible|
A LIRP isn’t worth it for most people, but there’s no “one-size-fits-all” approach to saving for retirement. The high cost of permanent policies (such as whole life insurance) — nearly half of which are surrendered within 10 years for that very reason — and the lower rates of return outweigh the benefits of having an additional retirement account for most people.
If you contribute the maximum amount to your retirement each year and don’t want to put additional funds into a traditional post-tax investment account, then a LIRP might be worth exploring. The best alternative to a LIRP is buying a term life policy and maintaining a 401(k) or Roth IRA. Even if you regularly max out your retirement accounts, a standard post-tax investment account can deliver a higher return on your contributions. And when you no longer need life insurance coverage, it’s simpler to drop term coverage than it is to cancel a permanent policy.
When a cash value life insurance policy is used to supplement traditional retirement funds (such as 401(k) and IRA accounts).
Cash value life insurance accounts are similar to a 401(k) or IRA account in that they are tax-deferred savings vehicles. But unlike a dedicated retirement account, cash value has more limited investment options and lower return rates.
Only permanent life insurance policies offer cash value components, thus making them 5 to 15 times more expensive than comparable term life insurance policies.
Life insurance terminology doesn't have to be confusing. Here are definitions of the most common terms and phrases you'll find in a policy.
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