How to Use Life Insurance as a Retirement Tool Safely

Introduction

Planning for retirement is such an important part of life. Permanent life insurance can accrue cash value, which you can access for retirement (and other) purposes. However, if you violate IRS limits and overfund the policy, or make other missteps, you can lose out and even get penalized.

In this guide, we will go over how to leverage life insurance cash value, risks to avoid, and how it supplements other retirement strategies.

Understanding the Role of Cash Value in Life Insurance

Permanent life insurance accrues cash value, unlike term life. Coverage lasts as long as you are on top of your premiums. This cash value can be accessed through tax-free withdrawals or loans for any reason, making your life insurance policy similar to an investment.

Permanent life insurance policies include:

Whole life insurance: Has predictable cash growth and guaranteed premiums.

Universal life insurance: Has cash growth with greater potential but less predictability. Premiums and death benefits can be adjustable.

Indexed universal life: Cash growth is linked to an index, like the S&P 500. Has caps and floors.

Variable universal life: VUL accounts have investment variety, which means you can usually select from several different funds in order to create a portfolio. You can withdraw or borrow from a VUL.

Coverage protection

The cash funds that the life insurance has accumulated can typically be used to pay off the premium if you fail to make a payment. This prevents coverage lapses, which provides peace of mind, especially to those who are juggling numerous monthly financial obligations.

Safe Ways to Access Cash Value

So your life insurance policy has accumulated cash value. Now what? How do you actually use that cash value to your advantage?

Four main methods exist to let you access your cash funds.

Withdrawals

Up to cost basis, the withdrawals will be tax-free. That means you can take out an amount that is equal to your total premium payments.

To withdraw, there needs to be enough funds in the policy. Make sure you’re aware of how much you’re withdrawing, and be careful to ensure you’re still able to make policy payments after withdrawal.

If you withdraw more than how much you’ve put into the policy, you would likely owe income tax. That can catch many policyholders off guard if they are unaware.

Policy loans

If you have cash value in your life insurance, you can borrow against it. This is considered a loan. You can use the funds in the account as collateral for the loan, obtaining money with terms and interest rates that can be significantly better than other loan options.

Surrendering the policy

Permanent life insurance can be surrendered. You will no longer have coverage (i.e. no death benefits possible, no cash value going forward) and you are cancelling the policy. You will no longer need to pay monthly premiums. When surrendering, you can get cash back, which is known as the cash surrender value.

There is a surrender fee that can be deducted from the cash surrender value. Unpaid loans can also impact the cash surrender value. Any penalties can be high depending on how early you are surrendering your life insurance policy and how much of a loan you owe.

Surrendering Paid-Up Additions (PUAs)

Paid-up additions let you invest additional funds into your life insurance policy. They are a rare, specialized form of fully paid life insurance policies. These small policies are purchased with dividends or extra payments. They offer protection to ensure your actual life insurance coverage remains active, sort of like a cushion.

However, PUAs can be risky to use. It can overfund the policy and end up pushing you to create a Modified Endowment Contract (MEC). An MEC would remove your tax advantages on loans and withdrawals from the life insurance policy.

For whole life holders, it is possible to surrender PUAs for you to access extra funds.

Important: When you access your cash value, it may reduce the policy’s death benefit if not repaid.

Risks of Overreliance on Life Insurance for Retirement

Life insurance is a valuable source of extra cash during retirement. However, it’s important to not over-rely on it. There are downsides to keep in mind.

• Can have higher premiums than traditional retirement accounts
• Policy lapse risk if loans or withdrawals drain cash value completely
• Modified Endowment Contract (MEC) consequences can have taxation and penalties
• Lower returns compared to dedicated retirement accounts (e.g. 401(k) or IRAs)

When Using Life Insurance for Retirement Makes Sense

You are a high earner

Anyone who maxes out 401(k) and IRA contributions can look for other retirement tools to supplement their retirement income. For them, using life insurance for retirement can be a great idea since it serves as an extra source of income and value.

You want tax diversification

Tax diversification is a powerful strategy that is part of saving efficiently for retirement. Anything that is tax-free or tax-deferred gives you flexibility. Even taxable accounts should be considered. Unfortunately, this process can be quite confusing since there are so many tax diversification strategies. A financial advisor is best suited to help you create a personalized strategy.

Life insurance as retirement tax diversification is one tool to consider. The cash value of a permanent life insurance policy is generally not taxable. That lets you grow it comfortably without worrying about taxes. Still, be aware that some taxes may apply if you withdraw (or borrow) an amount that *exceeds the total premium payments made.

You have long-term goals for estate planning or legacy

Whether it’s legacy wealth transfer or estate tax reductions, long-term estate-related goals can benefit from a permanent life insurance plan.

You want low volatility growth

Many life insurance policies come with a floor for the cash growth, which is usually 0%. This makes life insurance quite valuable for those who dislike market volatility, since other types of investments could lose you a terrifyingly high amount of money if you aren’t careful or lucky. With the floor, you can rest assured that even when the indexes are at their worst, the life insurance policy cash value won’t be hurting you.

Alternatives and Complements to Life Insurance in Retirement Planning

Defined contribution plans

Traditional retirement accounts like 401(k), 403(b)s, and 457(b)s can be used as the main retirement plans.

IRA plans

IRAs are provided by the American government. Traditional IRAs are tax-advantaged plans, so you can leverage the tax breaks with great efficacy for retirement.

When withdrawing from a traditional IRA plan, it becomes taxed at ordinary income tax rates. If you withdraw early, you can expect to pay an early withdrawal penalty.

Many types of IRA plans exist, including:

• Spousal IRA
• Roth IRA
• Rollover IRA
• SEP IRA
• SIMPLE IRA

Traditional pensions

Funded by employers, traditional pensions typically have a promised payout. They are very rare, however, when compared to other types of workplace plans.

Guaranteed income annuities (GIAs)

Annuities for guaranteed income can be used for retirement. Annuities let you convert a portion of your retirement savings into guaranteed lifetime income payments. It can be purchased with a lump sum or through premium payments over time. For retirement purposes, most people choose to start receiving their payments as they retire, though you are given options to receive it differently.

Taxable brokerage accounts

Flexible investments can be made through taxable brokerage accounts.

In general, life insurance should be combined with other retirement tools for balance and variety. The more options you have, the safer and more prepared you can be for retirement. You deserve a comfortable life in retirement.

Key Questions to Ask Before Using Life Insurance as a Retirement Tool

1. Have I maxed out tax-advantaged retirement accounts?

It’s generally recommended to max out and use other tax-advantaged retirement accounts before also using life insurance as a retirement tool.

2. Can I afford higher premiums without straining cash flow?

If you don’t have permanent life insurance yet, it’s the best time to consider whether the sustained monthly cost is something you can afford. If you end up having to surrender the policy because you cannot afford it anymore, it can result in fees and penalties.

3. Do I need both protection and supplemental retirement savings?

If you don’t actually need the life insurance part of life insurance, it might not be that useful for you. Consider what dependents or charities you want to leave the death benefit to. This death benefit protection is the major part of life insurance, after all.

4. How will accessing cash value affect my heirs or estate plan?

A lot of the time, people only access their life insurance cash value when there are few other choices to gain funds and it’s needed for retirement or emergency purposes. It is very convenient. However, keep in mind that accessing the cash value could affect your estate plan as a whole, and your heirs as a result.

Practical Steps When Using Life Insurance for Retirement

When it comes to retirement, better safe than sorry. If you have any complex financial needs or goals, it’s best to work with a licensed advisor experienced in advanced policy and retirement design.

In general, you want to avoid overfunding beyond Modified Endowment Contract (MEC) limits. If you accidentally get the MEC tax classification, it means you have overfunded the policy and violated IRS limits. A policy becoming an MEC loses several tax advantages that you were probably using the policy for in the first place. Cash value withdrawals would become taxable, and there may even be additional penalties depending on how early you are making the withdrawals.

Regardless of what policy you have or what growth type you have chosen, it’s a good idea to monitor policy performance regularly. That way you aren’t taken aback by how much cash value has (or has not) accrued. It’s often recommended to keep a mix of retirement income sources to reduce reliance on any single vehicle.

Take full advantage of the life insurance coverage portion

If you’re using life insurance for its cash value, but have no dependents or legacy goals that would benefit from the coverage part of life insurance, then permanent life insurance may not be for you. Other investment types may make more sense for your portfolio, since a lot of the cost that comes with life insurance premiums is in the main benefit: the life insurance death payout.

Remember to name someone or some entity as the beneficiary of your life insurance policy. Missing or incorrect beneficiary designations can make your loved ones or legacy goals lose out on a significant lump sum of money.

Conclusion

Life insurance can be a useful form of retirement supplementation. However, it should only be one tool among many. It’s not exactly the first form of retirement income that people should plan for, since 401(k)s and IRAs often make more sense and should be maxed out first.

So the safest, ideal approach to life insurance for retirement is to use it strategically when needed. Don’t become totally reliant on it.

Review your policy and retirement strategy with a financial advisor before making cash value withdrawals or loans. Here are the best life insurance policies to consider.