Consider a life insurance retirement plan if you have maxed out traditional retirement accounts. Known as permanent life, these plans offer the security of life insurance and the advantage of a tax-deferred savings account.
A life insurance retirement plan (LIRP) is an investment strategy in which a cash value, or “permanent”, life insurance policy supplements 401K’s or Individual Retirement Accounts (IRA’s). Although generally more expensive than “term” life insurance, permanent life insurance can be an effective retirement strategy under certain scenarios.
Difference between Term and Permanent Life Insurance
“Term Life Insurance” is the most common type of life insurance. Policyholders pay monthly premiums, determined by their age and health, for a ten, twenty or thirty year term. At the end of the term, the policy expires and the insurance ends. A benefit is payable to beneficiaries only upon the death of the policyholder. Individuals often purchase term policies to “insure” that their loved ones are provided for financially upon their death.
“Permanent Life Insurance” provides insurance for the whole life of the policyholder. It is an umbrella term that covers whole, universal life and guaranteed universal life insurance. Individuals pay premiums only until a certain age or for a set number of years. While a portion of the premium funds the life insurance, a percentage also goes into a savings account. That account grows, tax free, during the life of the policy. The savings account portion is the “cash value”. Because a portion funds the “cash value”, permanent life insurance premiums are higher. The length of time premiums are paid determines their amount.
How Does the Cash Value Work?
In the early years of the policy, the majority of the premium pays for the insurance portion. (A good analogy is a mortgage where the majority of early year loan payments go towards interest, or the cost of the loan.) As you pay premiums over time, the cash value grows more rapidly, through interest and dividends. The ratio of insurance cost to cash value is determine by the policy. The interest rate is generally lower (3-4% is typical) than other types of investments. This is due to life insurance company’s administrative costs. If you are looking for bigger growth, returns are generally better with a 401K, IRA or with stock market investments. However, market conditions may not guarantee that. Life insurance retirement plans can provide a guaranteed return and cushion against stock market swings
Accessing the Cash Value
There are several ways to access the cash value on a permanent life insurance policy.
- If the life insurance in no longer needed you can surrender, or cancel, the policy and collect the cash value accumulated. The surrender value equals the value of the policy minus any loans or fees. If you have had the policy for a number of years, this can be a good option. You pay taxes on the savings gains (beyond what you paid for insurance). However, in the early years of the policy, the cash value is small (because premiums are paying for insurance). With some insurers, canceling your policy during the first two or three years of the surrender period means that you will not receive any of the cash value. Other carriers charge fees of up to 10 to 12% for canceling a policy during its surrender period.
- You can take out a loan against the cash value. You will be charged interest but rates are generally lower than other types of loans. However, if the loan is not paid off before you die, or you want to surrender the policy, the amount of the loan deducts from the death benefit or surrender value.
- If the cash value of the policy is greater than the premiums paid, you can withdraw money. Generally, it takes at least ten years for that to happen making a permanent life insurance policy more attractive as a retirement vehicle. Because you pay for the whole life policy with after-tax dollars, you can withdraw from the cash value tax-free when you retire. However, any withdrawals can reduce the death benefit.
Whole, Universal and Guaranteed Universal Life Insurance
“Whole”, “universal” and “guaranteed universal” are variations of permanent life insurance.
“Whole Life Insurance” offers dividends on the cash value, although the dividends are not guaranteed. The dividends reinvest back into the cash value, essentially paying for an increase in the death benefit if you do not make withdrawals while alive. This provides an option of having your cash value pay premiums so your coverage will not expire.
With “Universal Life Insurance”, the cash-value component accumulates interest at a higher rate tied to market indexes. If interest rates are high, this gives the policyholder the advantage of reducing the premiums while growing the cash value more quickly. However, if interest rates decrease, you premium will increase as the life insurance company has to put more money in to maintain the policy’s cash-value component. Because of the premium fluctuations, initial universal life insurance premiums tend to be lower.
“Guaranteed Universal Life Insurance” reduces the riskiness of universal life by guaranteeing that your premiums will stay the same no matter how the market performs. However, if interest rates stay low, the savings portion may not accumulate enough to offer any kind of cash value. While this is good from an insurance standpoint and resembles term insurance with its lifelong policy, it is not good as a retirement vehicle.
Who should have a Life Insurance Retirement Plan?
Because of its higher cost and lower rate of return, a life insurance retirement plan is not for everyone. Financial experts generally recommend 401K’s and Individual Retirement Accounts as the best way to fund retirements. However, life insurance retirement plans make sense for the following:
- Individuals Who Max Out Their 401K’s & IRA Contributions
While most retirement plans have yearly limits on contributions, there is no limit for permanent life insurance plans. For high earning individuals needing another vehicle for tax-deferred savings, a life insurance retirement plan makes sense. - Individuals with Lifelong Dependents – For individuals who have dependents, permanent life insurance provides the peace of mind of a death benefit along with a cash value to provide for those loved ones.
- Individuals Looking to Retire in a Down Market – For individuals anticipating a stock market downturn when they retire, having a permanent life insurance policy allows them access to cash while waiting for their IRA’s and 401K accounts to recover.
- Individuals Looking to Retire Early – While there are penalties from withdrawing funds from a traditional individual retirement account or a 401K before 59 ½, individuals can withdraw the cash value of a permanent life insurance plan at any time, penalty-free.
- Individuals With Health Issues – Generally, the recommendation is for an individual to withdraw no more than 4% of the savings in a 401K or IRA account per year. However, if you think there is a probability that you will need access to funds to pay for large medical expenses or long-term care; permanent life insurance may make sense. Some policies even have long-term care rider or accelerated death benefits that kick in if you are terminally ill.
While permanent life insurance can be an important component of a retirement plan, it does not make sense for everyone. Before investing in a retirement vehicle, it is best to get the advice of a financial planning professional.