Strategies to Use Life Insurance for Retirement

Can the right life insurance policy help you meet your retirement savings goals? Yes, but maybe not in the way you’re thinking. While life insurance agents will try to sell you on the benefits of permanent life insurance that accumulates cash value, such policies usually only make sense for individuals with a net worth of at least $5 million, the threshold where estate taxes kick in after death.

For almost everyone else, the best way to incorporate life insurance into your retirement-planning strategy is to get the right death benefit for your family at the lowest cost so you have the most money left over to take other key steps toward financial security. Let’s take a look at how this strategy works.

Step 1: Buy Term

If you have a spouse or children who depend on your income or who depend on your “free” services as a stay-at-home parent or homemaker, life insurance should be part of your financial plan.

“It’s important for both working and non-working spouses to have life insurance,” says Kristi Sullivan, CFP®, Sullivan Financial Planning, LLC, Denver, Colo. “For the working spouse, you want to have enough insurance to cover large debts (mortgage), future obligations that can no longer be funded by the earnings of the deceased (college, retirement) and living expenses for the family. The non-working spouse needs to be insured to cover the cost of childcare and other household management work that the surviving breadwinner will now have to pay for.”

In other words, almost everyone needs life insurance. Even if you miss out on retirement because of an early death, you’d still like your spouse to be financially secure enough to have a chance at enjoying retirement, right? The least expensive type of life insurance, not just considering your out-of-pocket expense but also considering how much coverage you get for what you pay, is term life insurance. (For related reading, see Insuring Against the Loss of a Homemaker.)

Life insurance prices vary significantly depending on your age, health and policy features, but here’s one example that shows how much extra cash you could have to work with if you buy term instead of permanent life insurance. A nonsmoking, 35-year-old New York man in good health, meaning his blood pressure and cholesterol might be a bit higher than the ideal, might be able to get a 20-year term policy with a $1 million death benefit for $1,030 per year. If the same man bought a whole life policy, a type of permanent life insurance, the premium might be $14,090 annually for the same death benefit. That’s a $13,060 difference per year.

Given these costs, term life insurance can be an ideal retirement savings tool in two ways. First, it provides the basic financial protection your family will need if you pass away before you’ve accumulated enough savings for them to live off of. Second, its low, fixed price frees up more of your disposable income to create an emergency fund, purchase long-term disability insurance and invest in low-cost funds.

“A term life policy makes a lot more sense for many people,” says Mark Hebner, founder and president of Index Fund Advisors, Inc., in Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors.” “Given the lower premiums associated with the policy, investors will have more to invest for retirement, college or other financial goals they may have.”

How long a term you should buy depends on how long you think it will take to amass enough savings for your family to live comfortably without you. It also depends on your current age, because it can be difficult to get term insurance past age 65. How much life insurance you should carry depends on how much debt you have, how much income you need to replace and the cost of any future obligations you want to fund, such as a child’s college tuition. (See also: How Much Life Insurance Should You Carry?)

If you get life insurance as a benefit through work, your employer-provided life insurance may not be enough; you may need to supplement if with a policy you buy on your own. (See: Is Your Employer-Provided Life Insurance Coverage Enough?) Also, if you want the security of knowing that your insurance will be renewed each year as long as you pay the premiums and of knowing that your premiums will be the same every year for as long as the policy is in force, get a level-premium, guaranteed renewable and noncancellable term life insurance policy.

Step 2: Create an Emergency Fund

The first way you should put the savings from buying term life insurance to work is by building yourself an emergency fund of three to six months’ worth of expenses – maybe more, if you’re really risk averse or have an irregular income. Having an emergency fund prevents you from going into debt to handle times of increased expenses or reduced income.

Avoiding debt means avoiding paying interest; having to pay interest, especially at credit card rates, makes it that much harder to recover from a setback. A financial emergency often means temporarily stopping your retirement contributions; the sooner you can bounce back, the sooner you can get back on track with your retirement savings.

Step 3: Protect Your Income with Long-Term Disability Insurance

Ideally, you’d take this step at the same time as you’re building your emergency fund; there’s no reason to wait. While many people think they can get disability benefits from Social Security if a serious illness or injury prevents them from working, it is hard to qualify for these benefits and they might be far below what you’d need to maintain your household’s standard of living. What’s more, you won’t qualify for those benefits if you haven’t paid into the system; many public employees have not.

Among disability insurance policies, an own-occupation policy will cost you more than an any-occupation policy, but it will provide more comprehensive coverage. If you’re unable to work in your own profession – say, accounting – you won’t have to become a retail store greeter to get by; your disability insurance will replace a significant percentage of your lost income. Again, look for a guaranteed renewable and noncancellable policy, which ensures that your premiums won’t increase and you won’t have to worry about requalifying. You can keep the policy as long as you pay the premiums. Even if you're single and don't have children to support, having disability insurance is still important – maybe more so, as you don't have a spouse or other immediate family to help you get by should you become seriously ill.

Choosing the best disability insurance means either purchasing your own policy to protect your income and anyone who depends on it or making sure you have enough coverage through your employer. As personal finance guru Dave Ramsey likes to say, “your most powerful wealth-building tool is your income.” Without an income, you have no way to save for retirement. (Learn more in our Intro to Disability Insurance.)

Step 4: Invest the Rest

You’ve got life insurance, an emergency fund and disability insurance. Finally, let’s talk about investing the rest of the money you’ve saved by using term life insurance as a retirement tool.

While permanent life insurance policies have a cash value component that accumulates savings and can be invested, you’ll have the greatest control over your money and the potential to earn the highest returns if you invest it yourself, through the brokerage of your choosing, rather than through a life insurance policy. You won’t pay the high policy fees and agent commissions associated with permanent life insurance, your investment performance won’t be tied to the life insurance company’s financial performance, and you won’t be limited to the investments the insurance company offers.

You can set up a tax-advantaged retirement account at a brokerage that offers rock-bottom investment fees, which is one of the keys to growing your portfolio. You can create a well-diversified portfolio of uncomplicated index funds or exchange-traded funds. For even more hands-off investing, consider a target-date fund, which – depending on the fund's strategy – adjusts your portfolio mix to become more conservative as you get closer to retirement age.

The Bottom Line

Buying term life insurance and investing the difference isn’t what most people think of when considering how a life insurance policy can help meet their retirement savings goals. Yet, for most people, it’s the most effective strategy.

“If an investor is able to retire successfully, there is no more need for life insurance,” says James B. Twining, CFP, founder and CEO of Financial Plan, Inc., in Bellingham, Wash. “If the accumulated capital is sufficient to provide an income for life for a married couple, then it is certainly sufficient for a single survivor, whose expenses will be reduced.”