Roth IRA vs. Life Insurance

roth ira vs life insurance

In a few ways, a Roth IRA and life insurance share some similarities. They both receive favorable tax treatment in the IRS code. They enable efficient wealth transfers from one generation to another, and they can provide a tax-free legacy. But despite these similarities, Roth IRAs and life insurance are very different.

For one, a Roth IRA is a retirement plan while life insurance is, well, just that – an insurance product. Yet some people have been asking which of these options might be the “better” retirement planning vehicle.

However, it isn’t an 'either-or' question. Rather, it's what makes sense for someone based on their individual needs, goals, and overall financial picture.

That may include situations in which a life insurance policy is used as a tax-advantaged vehicle for income and income vehicle alongside some retirement accounts. Maybe even alongside a Roth IRA!

Nevertheless, it’s important to understand the differences between a Roth IRA and life insurance – including ways the rules may apply differently to them. With that said, here's a quick look at these two options.

Roth IRAs and Life Insurance -- Some Important Differences

Here are some key differences to keep in mind.

1. Roth IRAs come with more limits for contributions than life insurance does for premium payments.

Let's say someone chooses to have a Roth IRA and a cash value life insurance policy as part of their financial picture.

In the IRS tax code, life insurance has fewer restrictions than a Roth IRA does. Consider the restrictions on Roth IRA contributions, for example. For the 2021 tax year, annual contributions to a Roth IRA account are capped at $6,000 per person. If you are aged 50 or older, you have a contribution limit up to $7,000.

Then there is the matter of income phase-out range. Depending on how much your modified annual gross income is, you either might be limited in how much you can contribute to a Roth account, or you might not be able to contribute at all.

However, this isn't the case with life insurance. Under the IRS tax code, you may buy as much insurance as you want or can buy. There are also no restrictions on your income amount or how much insurance you "need" to purchase.

However, the life insurance company can place limits on how much insurance you can get.

Your financial professional can walk you through those details. Having a higher annual income may qualify you for even more life insurance, if you so choose.

2. You have fewer money sources you can use for contributions to a Roth IRA.

The tax code also doesn't pose any restrictions on the type of income you can use to buy life insurance. Life insurance premiums can be paid with any income source, including Social Security payments, dividends, interest, bank deposits, and so on.

On the other hand, annual Roth IRA contributions do come with some restrictions. Roth IRA contributions must come from income that qualifies as "compensation." Generally speaking, this tends to be earned income.

With life insurance, it doesn't matter if a contract is paid with a lump-sum premium or multiple premiums over time. You can still use any income source, or even your assets for that matter, to make premium payments into a life insurance contract.

3. The use of cash value life insurance for retirement may be affected by your insurability.

This is obvious, but as an insurance product, life insurance has the downside of being affected by your insurability. Personal conditions such as age, height and weight, family history, health status, and lifestyle come into play.

Even whether you participate in "risky" hobbies like scuba driving or world travel will affect your life insurance rates.

Based on these actuarial variables, the insurance company may be assuming more risk. So, if that is the case, your premium payments may be outside of what you are financially committed to putting toward a contract.

Your financial professional can discuss this with you if it might be an issue. In contrast, a Roth IRA has no such considerations for its annual contributions.

4. Don't forget about modified endowment contracts.

With life insurance, it's also important to be aware of modified endowed contracts. Some federal laws passed in the 1980s can affect the tax benefits of cash value withdrawals. Under these laws, there are limits on how much money you can use to fund a life insurance policy.

If the total sum of your premium payments exceeds the specific amounts permitted within the IRS tax code, the life insurance policy becomes a "modified endowment contract." Should that happen, the IRS no longer treats your policy as life insurance.

The death benefit for beneficiaries will be income tax-free, but cash value withdrawals will be subject to ordinary income taxes. As a result, the policy will lose its value as a vehicle for a tax-free income stream.

This article doesn't talk about the ins-and-outs of modified endowment contracts. But you can think of an MEC as a non-qualified annuity for tax purposes.

It's just like with tax-deferred retirement accounts. If you take withdrawals from a modified endowment contract before age 59.5, they can be subject to an early withdrawal penalty. You likely will be hit with a 10% penalty on top of ordinary income taxation.

That being said, there are ways to structure life insurance policies so you can avoid this possibility.

4. In estate planning, Roth IRAs are always included as part of an estate. 

As an individual retirement savings plan, a Roth IRA will always be part of an estate. So it will be included as part of the estate valuation.

Most families won't reach the federal exemption amount for estate taxes. But if yours does, your beneficiaries will have to pay federal estate taxes on what would otherwise be "tax-free" estate property.

Some states do have estate taxation laws. Among them, some states do have lower exemption amounts than the lofty exemption amount at the federal level. Be sure to review the tax laws of your state with personal guidance from an experienced attorney and an experienced tax advisor.

On the other hand, life insurance can be structured so it remains outside of an estate. So not only will life insurance proceeds be free of estate taxes, no matter your estate's valuation when you die, but it can deliver income tax-free benefits as well.

You can also bypass probate, which can cost a good portion of your estate value. A number of strategies can be used to accomplish this, including using an irrevocable trust to buy the policy.

Again, confer with knowledgeable estate planning and tax planning professionals for guidance. Your financial professional can help you with finding good life insurance options as well.

5. In some areas, life insurance may have more favorable tax code treatment.

We already discussed how a life insurance policy can be a truly tax-free estate planning benefit. Depending on how the policy is structured, you may also be able to use your life insurance policy as a source of tax-free income.

This can help reduce your tax liability in retirement, so ask your financial professional for more information if this might be of interest.

Not only that, there is yet another tax code advantage for beneficiaries.

Should you pass on a Roth IRA to a beneficiary or beneficiary who are not your spouse, required minimum distributions will kick in. Generally speaking, they will be required to start taking RMDs a year after they inherited the Roth IRA. However, those distributions can be tax-free.

In contrast, your beneficiaries have no required minimum distributions imposed on life insurance. That eliminates the hassle of having to deal with minimum withdrawal requirements year to year.

Another benefit for life insurance is found not in the distribution stage, but the purchasing stage. If a business purchases a life insurance policy, under certain conditions premium payments may be tax-deductible.

Because a Roth IRA is an after-tax retirement plan, tax-deducting advantages don't apply. Be sure to seek guidance from a qualified tax professional for more information.

Need Help with Your Financial Picture?

These are ways that Roth IRAs and life insurance differ, but they are just a few. No matter what your retirement accounts, insurance contracts, investments, and personal savings are, it should be right for you.

It's prudent to work with an experienced financial professional who acts in your best interest and can help you find options that make sense for your needs, goals, and situation.

Should you be ready for personal guidance in creating a tax-efficient and reliable plan for income and growth in retirement, financial professionals at stand ready to help you.

Use our "Find a Financial Professional" to connect with someone for a no-obligation consultation. And to request a personal referral, call us at 877.476.9723.

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