More on Life Insurance
More on Life Insurance
You can use a cash value life insurance policy to supplement your retirement income, but this strategy comes with a few risks. Here’s what you need to know before making a life insurance policy part of your retirement plan.
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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 this option as a major advantage of cash value life insurance. But while cash value policies sometimes offer flexibility in retirement financial planning, cash value life insurance also 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 financial strategy in which a cash value life insurance policy is used to supplement other retirement funds (such as 401(k) and IRA accounts)
Because cash value life insurance is expensive and complicated, life insurance retirement plans are not recommended for most people
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, or a LIRP, is a permanent life insurance plan that uses the cash value to help fund retirement. LIRPs mimic the tax benefits of a Roth IRA. 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.
You can access your policy’s cash value by withdrawing from it or taking out a loan against it, and that money can be used to provide tax-free income in retirement.
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LIRPs can both bolster your retirement savings 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.
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, allowing your IRA savings to replenish.
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-income earners 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 of your permanent policy go toward investing in your LIRP, and you can choose to add additional funds to that amount. It will cost more to buy permanent life insurance than term life: Whole life insurance premiums are five to 15 times higher, on average. You may find it more affordable to buy term and invest the money you save from not buying a whole life policy, rather than funding a LIRP.
|TERM & 401(k)||TERM & ROTH IRA||PERMANENT & LIRP|
|Monthly premiums||$29.96||$29.96||$149.80-$449.40 (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||$6,000 (below age 50); $7,000 (age 50 & up)||None|
Methodology: Rates are calculated for a 35-year-old female nonsmoker in Ohio, who qualifies for a preferred rate class, obtaining a 20-year, $500,000 term life insurance policy. Individual rates will vary as specific circumstances will affect each customer’s rate. Rate illustration valid as of 10/21/2020.
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. That’s because cash value 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).
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|
|The cash value of a life insurance policy is tax-deferred, like a 401(k) or IRA.||Cash value policies can be prohibitively expensive and difficult to maintain long-term.|
|There is no limit to how much money you can pay into a cash value policy.||Some insurers limit or charge administrative fees on cash value withdrawals depending on how long you’ve held the policy.|
|Whole life insurance and certain other types of cash value life insurance guarantee a minimum return.||Dedicated investment vehicles such as a 401(k) or IRA will likely provide better returns than a whole life policy.|
|There are no age restrictions on accessing your cash value, whereas there are penalties for withdrawing from an IRA or 401(k) before age 59½.||Cash value loans accrue interest until repayment. If you die before repaying, the loan plus interest is deducted from your death benefit.|
A LIRP isn’t worth it for most people. The high cost of permanent policies — nearly half are surrendered within 10 years due to lack of affordability — 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.
Rebecca Shoenthal is a life insurance editor at Policygenius in New York City, specializing in buying life insurance and the ins and outs of life insurance ownership. She's edited business books by the country’s top academics, politicians, journalists, thought leaders and CEOs, including venture capitalist John Doerr’s Measure What Matters, entrepreneur Scott Belsky's The Messy Middle, NYU Stern professor Scott Galloway's The Four, and technologist John Maeda's How to Speak Machine.
Rebecca has a B.A. in Media and Journalism from the University of North Carolina at Chapel Hill.
Amanda Shih is a life insurance editor at Policygenius in New York City. She has a passion for making complex topics relatable and understandable, and has been writing about insurance since 2017 with specialities in life insurance cost and policy types. She's previously written for Jetty and LegalZoom.
Amanda has a B.A. in literature and communication from New York University.
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