You probably think of life insurance as coverage for your loved ones upon your death. But what if it could also be part of your retirement plan? Certain life insurance policies, such universal life, provide benefits while you’re still alive, and benefits for your beneficiaries upon your death.
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If you find yourself short on funds during retirement, whether you lived longer than expected or ran out of money faster than you planned, your life insurance may provide help.
Find out how life insurance can be a part of your retirement plan.
What Insurance Policies can be a Retirement Plan?
First, let’s be clear; a term life insurance policy isn’t part of a retirement plan. The only way to access cash from a term policy is if you die. Your beneficiaries receive the death benefit upon your passing – you can’t use any of it while you’re alive unless you have a special rider for specific situations, such as permanent disability.
If you die while your term life policy is in effect, your loved ones receive your death benefit. If you outlive the policy (which is good), the policy expires and ends. You don’t have any cash value to draw on.
What is a Whole Life Insurance Retirement Plan?
A whole life insurance plan may be an option to supplement your retirement. Whole life insurance or permanent life insurance has a death benefit, like term life insurance, but it also has a cash value. It’s the cash value that may help you during retirement.
After you pay your premium, any extra money in your payment goes into an interest-bearing or investment account, depending on the policy. Your earnings grow tax-deferred, and you only pay taxes when you withdraw the funds.
You can use the funds in an emergency to pull out a lump sum or supplement your income. Any money you withdraw reduces your death benefit dollar for dollar. You can withdraw as a loan or as a direct withdrawal, but again, you decrease your death benefit by doing so.
Indexed Universal Life Insurance for Retirement:
If you want something a bit more robust (and possibly riskier), consider investing in indexed universal life insurance for retirement policy. It works like the whole life policy with its cash value and death benefit, but the cash value is invested rather than just earning meager interest.
The main difference is there is no guarantee of a return. Index universal life insurance is based on the market’s performance. If the market does well – your account does well. If the market tanks, your account tanks.
Indexed universal life also has flexible premiums. You choose how much you pay each month, as long as you cover the minimum premium for the death benefit. During times when money is tight, you can pull back only making minimum payments, but when money’s good, you can pay as much as you want with the excess going into your investment account.
This type of policy has higher risks, though. There’s no guarantee your earnings will grow, and it depends on the market and chosen investments.
Transferring your Life Insurance to an Annuity for Retirement
Here’s where using life insurance for retirement pays off. Once you have a decent nest egg in your cash value, you can convert it to an annuity. You buy the annuity from the same insurance provider ad because you’re exchanging the funds from one investment to another, it doesn’t trigger a tax liability. The IRS calls it a 1035 exchange, which allows you to avoid taxes.
You buy the annuity with one lump sum (the excess cash value of your life insurance policy), and the insurance company pays you a specified lump sum each month. If you purchase a lifetime annuity, you receive benefits for your lifetime.
Keep in mind:
If you convert your whole life policy into an annuity, you give up the death benefit. By the time you’re in retirement, though, your beneficiaries may not need the death benefit. You using your funds during retirement could be the best use for the funds.
Life Insurance Retirement Plan – Pros and Cons:
- Build a cash-value tax-deferred
- No funding limits like the IRA or 401K have
- Whole life policies have a guaranteed return
- There’s a death benefit for your loved ones if you die prematurely
- There aren’t any early withdrawal penalties
- Whole life insurance cash value grows slowly
- Universal index life insurance cash value is risky
- No tax benefits (deductions for contributions)
Is a Tax-Free Retirement with Life Insurance Possible?
If there’s one thing that stands in most people’s way during retirement, it’s the taxes. Each program handles taxes differently:
Traditional IRA – You contribute funds each year tax-free. When you withdraw the funds during retirement, you pay taxes according to your tax bracket at that time.
Roth IRA – You contribute funds each year after taxes. Your contributions and earnings grow tax-free, and your withdrawals are tax-free too.
Life insurance retirement plan – Your contributions are after-taxes and your earnings grow tax-deferred. You pay taxes only on the amount you withdraw that exceeds the amount you contributed (your basis).
So is there a tax-free retirement with life insurance? It is, but only if you withdraw your contributions and none of the earnings. A tax advisor can help you determine the right amount to withdraw if your goal is to avoid a taxable event.
Should you Overfund your Life Insurance for Retirement?
If you want enough funds available for your retirement when paying your life insurance, you may wish to overfund it. This means paying much more than the required premiums, so not only do you cover the death benefit premium, but you contribute to your cash value.
Can your Life Insurance Policy Cash Value Supplement your Retirement Income?
Many people use their life insurance to supplement their retirement income, especially during ‘down years.’
Let’s say you have an IRA that you withdraw 4% of your savings each year during retirement. One year, though, is particularly bad. The market does poorly, and your investments don’t grow. Rather than depleting your IRA even further by withdrawing your 4 percent, you could turn to your life insurance policy to supplement your income.
This gives your IRA time to catch back up but keeps your retirement income stable.
The Employer Retirement Plan vs. IRA vs. Life Insurance Retirement Plan
So you have all these options in front of you, what do you choose?
Here’s an excellent way to break it down:
Always invest in your employer retirement plan if they match any of your contributions. It’s like free money – don’t give it away. Contribute what you can and get the bonus money from your employer.
Contribute what you can to an IRA if you have extra funds after funding your 401K. In 2020, you may contribute up to $6,000 in your IRA. Your earnings grow tax-deferred or tax-free, depending on the account type opened.
Fund a life insurance policy, just in case. Because we can’t predict the future and we don’t know what might happen to our retirement accounts moving forward, having a life insurance policy is good ‘insurance.’
Here’s the deal:
Should you use your life insurance policy for retirement? You shouldn’t rely on it as your sole source of retirement income. If you use it as a backup, though, it’s a good idea.
What happens if your retirement investments take a dive before you have a chance to pull back to conservative investments when you near retirement? If you don’t have a life insurance policy, you may not have anything to fall back on, which could spell trouble. If you have other investments, such as taxable investments or even a savings account, you may rely on that, but will it be enough?
A life insurance policy as a retirement plan may be an option for some. We don’t recommend using it as your only retirement plan, though. It should be a ‘just in case’ policy that if you don’t use the cash value, serves as a death benefit for your loved ones.
If you use the cash value during retirement, know that you decrease your policy’s death benefit. This means your loved ones receive less money when you die. If you live well into your retirement, your beneficiaries may not need the money, except maybe to cover your final expenses. In that case, use your life insurance proceeds, after all, you are the one that contributed the funds!