Can Life Insurance Be a Retirement Plan?
March 28, 2016Listen to the radio these days and you’re likely to hear a commercial promising tax-free retirement income with no stock market risk. If you call a toll-free number or sign up on a website, you will probably get a follow up contact from a life insurance agent who wants to show you how you can use whole life or universal life insurance for tax-free retirement income. Doesn’t that sound too good to be true? Can permanent life insurance really be a retirement plan?
Be very, very cautious. Life insurance is not designed for retirement savings. Permanent life insurance is primarily designed to protect people in your family who rely on your income to maintain their standard of living. The “permanent” aspect means that this insurance protection stays with you for your life, as long as you pay the premiums.
Both major types of permanent insurance — whole life or universal life — include a death benefit component and a savings component. The savings component consists of a policy cash value, the amount of accumulated policy value which would be paid out to the insured if the policy were surrendered early. The “life insurance as retirement cash flow” strategies are based on the insured person borrowing against the cash value of their policy. While it is correct that you may borrow against the cash value in some circumstances without taxes, and that invested premiums grow tax deferred, there are some significant disadvantages.
A Loan is Not Income
A policy loan uses the cash value of the policy as collateral, and the insurance company charges the borrower interest on the loan. The interest is paid to the insurance company, not back to you. The interest rate may be the same, higher or lower than the rate you are crediting on the growth of the policy cash value. Financial planning expert Michael Kitces aptly calls this borrowing strategy, “nothing more than personal loan from the life insurance company.” That’s not real income.
Policy Dividends Helpful But Not Guaranteed
What about dividends? While certain types of insurance companies pay dividends to policyholders (who hold a “participating” policy) when their annual results are good (those dividends can be applied towards future premium payments or used to purchase additional coverage), they aren’t always likely to make profits every year. You may or may not receive dividends.
Potential Tax Problems
If you are eligible to receive policy dividends from a participating policy, they are not taxable. However, strategies that recommend borrowing against cash value life insurance have potential tax problems. Should you borrow enough of your cash value so that the basis in the policy goes down to zero, you would have to put in more cash or risk a lapse of the policy and having the total outstanding loans included in your taxable income.
No Free Lunch
Another disadvantage of using life insurance as retirement savings are the fees. You’re paying for the insurance component. If you died early, your beneficiaries would receive the full death benefit, so you’ll be charged underwriting costs and mortality charges, etc. Plus you are paying for the distribution of the policy, in other words, commissions. Someone’s getting paid, and those fees and charges eat into the type of returns you might otherwise earn if you invested the money into buying and holding tax-efficient index funds.
The Bottom Line: Do You Need Permanent Life Insurance?
Consider a life insurance proposal primarily in the context of your estate plan, not your retirement plan. Lifehappens.org has an overview of insurance basics and a helpful calculator to figure out how much insurance you actually need. Does the proposed policy meet your needs of providing for your family should something happen to you? Are you comfortable with/interested in having insurance protection you can’t outlive? How do the costs of this policy compare to costs of policies from other companies with the same face value?
If the life insurance meets those needs on its own merits, then your ability to borrow from it later on is an extra bonus. If paying premiums on this kind of life insurance policy are preventing you from other, more effective types of retirement savings, such as maxing out your tax-deferred retirement plans like your 401(k) and IRA/Roth IRA, that could do serious damage to your financial wellness. If you are on track for retirement, have low/no debt and need permanent insurance, then there may not be any harm. Don’t think of it as a retirement income strategy, however. Think of it as life insurance with access to a personal loan.
Do Your Homework
If you are considering one of the currently popular life insurance cash flow strategies, here are some questions to ask the insurance agent about your proposal:
- How do you get paid?
- What are the other fees involved — mortality, underwriting, surrender charges, investment management, etc. Where can I see them reflected on your proposal?
- What is the interest rate I’d be charged if I borrowed against my cash value?
- What is the rate I’ll be credited on my cash value?
- If I borrow from my cash value, can I repay that at any time? Are interest payments deducted from the cash value, or do I write checks for them?
- What happens to the policy if I borrow the entire cash value?
- What is the actual return net of all fees?
- What’s the worst case scenario? Are there any circumstances in which I could be taxed? Lose money? Lose my insurance?
How about you? Do you have a personal finance question you’d like answered on the blog? Email me at [email protected] or follow me on Twitter @cynthiameyer_FF.