Are you a high earner?
Are you considering retiring early?
If so, you may want to look at insurance as a retirement savings vehicle. This permanent life insurance option has both advantages and pitfalls.
How Does Insurance Translate into Retirement Savings?
Most people think of the “death benefit” when purchasing an insurance policy. In a simple term insurance policy, you pay money now so that when you die your beneficiary gets the insurance benefit. There are other types of insurance which may be suitable as part of your retirement income stream.
Cash value life insurance is a form of ‘permanent’ (includes whole and universal) life insurance. Part of the insurance premiums are invested in mutual or investment funds, designed to increase in value, boosting the ‘cash value’ portion of the insurance policy. The money in the policy grows tax free, similar to the funds in an individual retirement account or 401(k).
At a later date, you may withdraw some of the funds from the cash reserves of the insurance and use the money as retirement income. (For related reading, see: Permanent Life Policies: Whole vs. Universal.)
When is Insurance Right for Retirement?
There are limits on the amount one is allowed to contribute for retirement in traditional accounts such as a 401(k), 403(b), and IRA. Furthermore, except under special circumstances, the account owner may not withdraw money from these types of retirement accounts without penalty before age 59½. This creates a problem for someone interested in retiring before age 59½.
If an individual is looking for someplace to save more money for retirement in a tax advantaged account, and is considering retiring before age 59½, he or she may consider a permanent insurance policy. (For more, see: Cut Your Tax Bill with Permanent Life Insurance.)
Another possible advantage to including insurance as part of retirement planning is that when the cash is invested by the life insurance company in a general account, the returns aren’t necessarily correlated to stock market returns. Specifically, uncorrelated investments mean that when one investment falls, such as a stock mutual fund, another may go up and cushion the negative impact of the declining asset, and vice versa. This would give your overall portfolio added diversification and a cushion from the volatile stock and bond markets.
Disadvantages of Funding Retirement with Insurance
Cost is a major drawback to this approach of retirement funding. Premiums are much higher for these types of policies than for a simple term insurance policy. There are very large fees attached to permanent life insurance policies as well.
The growth you achieve in the policy may not be as robust as that of a diversified stock and bond mutual fund portfolio held in a discount investment brokerage account. In general, a well balanced index mutual or exchange-traded fund portfolio offers lower expense ratios and higher returns than those reported by most permanent insurance policies.
Investments held within insurance policies frequently promise overly-optimistic investment return projections. If the returns don’t perform as expected, then the amount available for spending will be lower than expected. This may force you to make larger premium payments for a longer period of time than originally anticipated. (To learn more, see: Buying Life Insurance: Term Versus Permanent.)
Although you are eligible for tax-free withdrawals from the policy’s cash value up to the policy’s cost basis, through loans or partial withdrawals, there are other factors to consider. Loans can lead to negative tax consequences if too much cash is withdrawn or the loan balance surpasses the cash left in the policy and the loan isn’t repaid. Additionally, you’ll owe interest on the borrowed money to the insurance company.
When taking withdrawals from a cash value insurance policy it’s important to review all of the consequences with the insurance broker or a financial advisor and make sure you understand the advantages and disadvantages of this strategy. (For related reading, see: Shifting Life Insurance Ownership.)
The Bottom Line
If you’re looking for increased retirement savings, the first step is to contribute the maximum to all available retirement vehicles. Only after you’ve maxed out those options, should funding retirement with insurance be a consideration. It is wise to make certain that you completely understand the permanent life insurance policy and its fee structure. (For more, see: Life Insurance: Putting a Price on Peace of Mind.)