Life insurance: The retirement savings vehicle you may have missed

Cash-value life insurance offers unique advantages for high-income individuals

A well-rounded retirement plan typically includes a variety of savings vehicles, such as an individual retirement account (IRA), Roth IRA or 401(k), plus real estate holdings, after-tax investments – and even life insurance. Many individuals don’t realize that the right life insurance policy can play an important and unique role in retirement savings.

In contrast to other retirement savings vehicles, there are no income limitations on who can purchase or contribute to life insurance policies and partake in their tax benefits, so this can be a particularly attractive option for high-income earners.

How can life insurance provide retirement income?

Accumulation-based, cash value life insurance strategies are designed with a death benefit that maximizes tax deferred growth of the account value. The owner pays what is typically a flexible premium with after-tax dollars for a set number of years. The cash value of the policy grows tax deferred as long as the policy stays in force.

For example, one strategy might be to pay premiums starting at age 40 for 20 years and to take distributions from the policy in the form of a loan starting at age 65 for 20 years. The loans would come out either annually or monthly, income-tax free to the insured. Depending on the underlying insurance products, you can have access to a variety of options, including some that have downside protection. The death benefit is paid out income-tax free after any outstanding loans are repaid.

Insurance advisors often talk about cash-value life insurance as a customizable personal pension because you can access an income stream from the policy, similarly to the way a pension might be distributed to you. The difference is that you get to pick how much you withdraw or borrow each year – or if you want to take out anything at all.

Life insurance offers several advantages as a retirement savings vehicle

Life insurance occupies a unique place in the tax code. A policy with a cash value component grows tax-deferred, with no tax on interest, dividends or capital gains. Moreover, the policy’s death benefits are not subject to income tax.

There are several benefits to including cash-value life insurance as part of your retirement income planning:

• No income limitations that phase-out the ability to contribute or to enjoy tax benefits
• No impact on the ability to contribute to other retirement savings vehicles
• No required minimum distributions
• No early withdrawal penalties
• Distributions are not subject to federal, state or local income tax; capital gains tax; or net investment income tax
• Distributions are not subject to the alternative minimum tax
• Distributions do not increase Medicare premiums or the percentage of Social Security benefits that are taxed
• Significant flexibility in how much you contribute to the policy each year
• Tax-deferred asset growth
• Income tax-free death benefit to your beneficiaries

To maximize these benefits, both the policy and the distributions need to be structured properly. In addition, a policy’s death benefit, while income-tax-free to beneficiaries, could be subject to estate tax. Sometimes, estate taxes can be minimized by having the insurance policy held in an irrevocable life insurance trust. An estate and trust professional can help you structure distributions, death benefits and your estate to minimize the tax consequences.

Understand cash-value life insurance types and how they fit into retirement income strategy

There are three main types of cash value life insurance, based on their level of risk. The lower the level of risk, the less opportunity the money you put into the policy has to grow. The higher the risk, the more growth opportunity it has.

1. Whole life insurance: Often considered the most conservative option and the most costly, whole life insurance is sold by well-established mutual insurance companies where the policy owners own the insurance company. Profits of the insurance company are paid to the policy owners in the form of dividends that can be added to the cash value or used to pay future premiums. Whole life policies typically have guaranteed cash values and guaranteed death benefits.
2. Indexed universal life insurance: The most popular option these days – and also the most complex – is indexed universal life insurance. In this type of policy, the returns of the account are tied to the returns in an underlying index such as the S&P 500. These policies usually limit your downside on returns to 0% in conjunction with capping you on the upside. There are dozens of insurance companies, each with different index options, floors, caps, participant rates and fees, so confirm that you are working with an independent advisor who will seek out the best options for you and your family. These policies may allow you to guarantee the death benefit for an additional fee.
3. Variable universal life insurance: The most aggressive option and often the riskiest, variable universal life insurance is the only type of life insurance that has access to mutual funds. A portion of the premiums you pay into the policy are invested, and there is no cap on the maximum possible rate of return. However, there is also no guaranteed minimum return, and the cash value of the account can decrease if the value of its holdings decreases. The death benefit on newer versions of these policies can be guaranteed for an additional fee. These policies can only be sold by an insurance professional who is registered with a broker-dealer.

If you’re considering including cash value life insurance as part of your retirement plan, your policy choice should consider your risk tolerance and how the policy fits into your overall portfolio. Tax, wealth, and insurance advisors can help you understand how cash value life insurance fits into your overall strategy.

At Kaufman Rossin, we understand that life insurance is just one component of your overall financial, retirement and estate plan. We can bring together insurance, financial planning, tax, and estate and trust professionals to help you understand and choose each aspect of your financial planning strategy, as well as maximize the tax benefits of options such as cash value life insurance. Contact us today to discuss your options.