A Closer Look at Using Life Insurance for Tax-Free Income in Retirement

People have a variety of accounts that they can use to save for retirement. You might have heard of some of them before. IRAs, 401(k)s, 403(b)s, and 457(b) accounts allow workers to put away money on a pre-tax basis and then take it out in retirement as taxable income.

What if you are worried about taxes? Then you can opt for a Roth account, in which you put away money on which you have already paid income taxes. The benefit is on the backend, where you can draw it out tax-free in retirement.

The good news is there are other ways that you can have even more tax-free income in retirement. These options can be a good supplement to a Roth account. So long as it’s properly structured and used correctly, an indexed universal life insurance policy can be one such vehicle. An IUL policy lets you build cash value by putting in premiums with after-tax money, then later take out money tax-free.

What’s more, policyholders also have a complete package of insurance benefits on top of their retirement income. Many IUL policies today provide living benefits for critical illness, chronic illness, and terminal illness. These benefits let you use proceeds to cover costly expenses in those health situations.

How Did IUL Insurance Come About?

IUL insurance can essentially be thought of as third-generation life insurance.

First generation life insurance was the traditional whole life insurance and universal life insurance. These kind of life policies paid either a fixed rate or a variable rate that adjusted with interest rates in the economy.

Then variable universal life insurance came along, allowing you to put your premiums into different investment fund options. Over time, variable life policies declined in popularity as strong market volatility arose in the 2000s.

IUL insurance became more prominent as an alternative. You can think of this type of life insurance as a sort of happy medium between guaranteed life insurance policies and variable universal life policies. The guaranteed life insurance policies have relatively low interest rates, and variable universal life insurance policies come with market risk.  

How Does IUL Insurance Work?

With IUL insurance, the cash value in the policy is linked to an underlying financial benchmark index. A common benchmark used is the S&P 500 price index. When the index goes up, the cash value is credited with interest earnings based on a portion of that growth.

When the index falls, the cash value simply remains the same. It’s credited zero percent for that period. Your principal and prior interest earnings are locked in. The IUL policy provides guaranteed protection of principal for your money in this regard.

IUL policies won’t have as much growth potential as variable universal life policies over time. But many IUL policies can have growth potential above the rate of inflation.

Your money will also likely earn more interest in an IUL policy than you would in a bank CD or other bank products, which currently pay very little interest.

A Growing Place of Using Life Insurance in Tax Planning

With swelling government debt and spending, tax hikes have increasingly become the talk of the town. Because of that, there is growing interest in IUL policies, and permanent life insurance policies in general, as another source of tax-advantaged income.

Other types of tax-deferred vehicles such as IRAs and qualified plans can be changed according to the whims of legislators in Congress. As these pressures build, they may well seek ways to generate additional tax revenues at the expense of the wealthy. But the taxation of life insurance has been pretty consistent for decades.

Nor is the use of life insurance in this way a new concept. Historical figures such as President John F. Kennedy, President Franklin D. Roosevelt, and even Senator John McCain have used life insurance policies to great financial benefit in different ways.

A Swiss-Army Knife of Benefits

IUL insurance with living benefits can provide value in many respects. You can tap the cash value for tax-free income, and you can also have a good amount of flexibility in how you use the income. This can be attractive as part of a comprehensive strategy to reduce taxes in retirement.

What’s more, IUL also gives you a package of insurance benefits that may be more expensive if they were purchased separately.

One big advantage with an IUL policy is the certainty that the policyholder will receive some sort of benefit from it. Policyholders are guaranteed to get their money out of these policies one way or another.

They may receive proceeds from living benefits if they become disabled or are diagnosed with a major illness. Their beneficiaries have claim to the death benefit should they pass away prematurely.

If none of these things happen, then the policyholder can still access the cash value in the form of tax-free policy loans during retirement.

The downside to this? Of course, these loans do charge interest. Any outstanding loans that have not been repaid by the time the policyholder dies are subtracted from the death benefit. Still, the policyholder is covered no matter which way things turn out.

What Are Some Disadvantages to This?

In most cases, the policyholder will have to make premium payments for at least ten years before the cash value in the policy really starts to grow. This is because the first ten years’ or so worth of payments are used to pay for the insurance benefits.

For this reason, many financial professionals focus on people in their forties or fifties and who can make premium payments over this time. This helps ensure that the cash value will have adequate time to grow before the policyholder retires.

Also, the policy must be structured so that excessive premium payments won’t turn the policy into a modified endowment contract (MEC). An MEC doesn’t have the same tax advantages that a traditional cash value life insurance policy has, so care must be taken in this regard.

Working with an experienced financial professional who understands life insurance and how this works can help you avoid this situation.

Life insurance policies also can have a variety of fees or expenses, so be sure to cover those with your financial professional when exploring different options. There may be certain life insurance contracts that are better for your unique situation.

A Quick Overview of Policy Loans

Another key advantage to IUL policies is their loan provisions. Once you have built up adequate cash value in your policy, you can borrow from the policy on a tax-free basis. You don’t have to repay it if your cash-flow doesn’t accommodate this. Interest will be charged on the loan, and if the loan isn’t repaid, it will be deducted from the death benefit proceeds.

For example, say someone has an IUL policy with $100,000 of cash value built up inside it. Then they take out a loan for $40,000 to buy a new car or make improvements on their home.

If they passed away soon afterward, then their beneficiary would receive a reduced death benefit. But you won’t pay a 10% early withdrawal penalty on your withdrawal if you are under age 59.5 like you would with an IRA or a qualified plan. There is no age limit for taking money from the cash value as there is with most retirement savings accounts.

Should You Use Life Insurance in Your Tax Strategies?

Using life insurance for tax-free income can be beneficial as part of an overall tax planning strategy. Index universal life insurance is popular among high-income taxpayers in many cases because of their ingrained tax advantages. However, growing numbers of other policyholders are also finding value in it.

You might be inclined to explore other permanent life insurance, such as whole life insurance, for your tax planning mix. But, overall, is this strategy for you? Who would be a good candidate for using life insurance in a tax planning strategy?

Those who are in their mid-career and have consistent income earnings per year are one. Since the cash value takes time to grow, it’s important to have a long enough timeline for that before retirement. You also want to be able to keep up the premium payments over the years so your cash value can grow.

Your financial professional can walk you through the pros and cons, as well as other details relating to your situation. Don’t hesitate to ask questions or seek clarity if something doesn’t make sense. This is your money, and you want it to work well for you now and in retirement.

Taxes Are Just One Part of Retirement Planning

Of course, taxes are just one part of the retirement financial picture. You should also have enough income for your desired lifestyle in retirement, not to mention have financial resources in place for other situations like healthcare needs.

If you are looking for a financial professional to help you with this, many independent financial professionals are available at SafeMoney.com. They understand retirement and its unique opportunities, challenges, and nuances.

Get started by visiting our “Find a Financial Professional” section to connect with someone directly. You can request an initial appointment to discuss your goals, concerns, and personal situation. Should you need a personal referral, please call us at 877.476.9723.