When squirreling away retirement funds, a 401(k) plan is an obvious place to start, especially if your employer matches a portion of your contribution. But where do you go once you’ve contributed the max for the match, or if your place of work doesn’t offer a qualified plan retirement plan at all? Many workers continue to fund their workplace plan, but you have some other options, too, including using a life insurance policy.
In certain cases, the insurance-as-investment approach can be a wise move, but usually for wealthier investors. Everyday investors who have maxed out their allowable 401(k) and individual retirement account (IRA) contributions, however, should evaluate whether the sizable fees of life insurance policies would outweigh any potential tax benefit for them.
Using life insurance policies to save for retirement may benefit the wealthy, but given the considerable cost of these policies, everyday investors might be better advised to use a simpler vehicle, like an IRA.
IRA or 401(k)
Between these two strategies, an IRA is a more straightforward way to save for retirement. You simply create an account with a brokerage firm, mutual fund company, or bank, and select the investments you’d like to make with your contributions. These can include everything from individual stocks to mutual funds and gold bullion.
The main perk of these accounts is their tax treatment, which is similar to the 401(k)'s. With a traditional IRA, your qualified contributions are tax-deductible, and the investments grow on a tax-deferred basis. There are limits. For the 2020 and 2021 tax years, the maximum contributions for IRAs are set at $6,000, plus another $1,000 if you are 50 or older.
For non-Roth 401(k) plans, the maximum contribution for the 2021 tax year is $19,500 plus $6,500 for those 50 or older. After retiring, you'll pay ordinary income tax on whatever amount you withdraw.
A Roth IRA has similar benefits but in reverse. You invest using after-tax dollars (so no tax deduction at that time), but you don’t pay a dime in additional taxes on the accrued funds, as long as you’ve owned the account for at least five years and have reached age 59½ before making a withdrawal.
Permanent Life Insurance
Another possible route is to buy permanent life insurance. In addition to offering a death benefit for your survivors, these policies also feature a savings component. Part of your premium goes toward your death benefit; another portion builds up your cash-value account, which grows on a tax-deferred basis.
Whole Life Insurance
Permanent life insurance policies are a little complicated. Each time you pay a premium, part of it goes toward a cash-value account. With a whole life insurance policy, the carrier credits your account by a certain percentage based on how its own investments perform. If you’ve had your policy for a few years, you’ll typically see annual returns in the 3% to 6% range, often earned in tax-free investments.
Variable Life Insurance
Other types of permanent life insurance work a little differently. For example, with a variable universal life insurance (VUL) policy, the amount of the credit is tied to the performance of stock and bond funds of your choosing. The potential returns are higher, but so is the risk. If the market loses ground over a given period, you may have to pay a higher premium in order to keep your coverage in place.
Investors who rely on life insurance for retirement needs should think long-term—it can take 10 to 20 years to build up a sizable cash-value account. Once your balance is big enough, there are a few ways you can draw on your policy for personal needs. Paid-up additions (PUA) are a good way of increasing the amount of cash value in a policy for low relative cost and which can maximize retirement income later on.
Another possibility is to make periodic withdrawals. As long you don’t pull out more than your basis—that is, how much you paid in premiums—you won’t experience a tax hit for doing so. Any additional amount is subject to ordinary income tax rates. To keep the Internal Revenue Service (IRS) at bay, some folks stop making withdrawals once they reach their basis. From there, they take out a loan against their policy, which is usually tax-free.
Surrendering Your Policy
Yet another option is to surrender your policy and get the cash-value in one lump sum, minus any outstanding loans. But there’s an important catch: Any time you take money out, you’re decreasing the death benefit for your heirs. If you take a loan against your policy, you have to pay it back with interest in order to build it back up again. And if you surrender it, you’ll probably lose your coverage altogether.
Compare this to someone who buys a much cheaper term life insurance policy, which has no savings feature, and invests the difference in an IRA. They can dip into their savings at any time after age 59½ without affecting the insurance or its payout if you die. And they can leave any remaining balance to their family members, which can’t be said of your cash-value account.
- Retirement savings can grow in a tax-advantaged way for disbursement later in life.
- 401(k) plans and IRAs allow tax-deferred growth in investments, which are then subject to income taxation upon withdrawal, and which come with penalties for early withdrawal.
- Permanent life insurance policies can also be built to accumulate retirement savings, and disburse funds tax-free if designed correctly.
A Costly Approach?
Perhaps the biggest knock on permanent life insurance policies is their up-front cost. First, there’s the initial fee that helps pay the agent’s commission. Often, this can eat up half of your first-year premiums. Consequently, it takes a few years for your cash-value account to really start growing.
On top of that, policyholders tend to face steep investment fees, often around 3% per year. By contrast, the average expense ratio for open-end mutual funds and ETFs offered for sale is 0.52%. So investing in an IRA allows you to eliminate this significant drag on your returns.
But that’s not all. You also have to worry about surrender charges if your policy lapses within the first few years. You’ll lose not only your death benefit but also a considerable portion of your cash balance as well. With most policies, the amount of this fee gradually decreases over a period of years and then disappears.
However, if you are committed to long-term strategies, permanent life insurance policies that are designed to accumulate extra cash value will tend to break even around the tenth year of the policy. Moreover, cash is accumulating every year before that, so if you did surrender the policy, you would receive some money back and not be out the entire amount of premiums you have paid.
When Insurance as an Investment Makes Sense
Does it ever make sense, then, to use life insurance as an investment? The answer is "absolutely—in some limited cases."
For example, wealthier individuals will sometimes set up what’s known as an irrevocable life insurance trust so their heirs can avoid estate taxes. Technically, the trust is paying the premiums for the life insurance policy, so the death benefit isn’t considered part of the deceased family member’s estate.
Beyond that, life insurance is sometimes a reasonable choice for everyday investors who have maxed out their allowable 401(k) and IRA contributions. But even then, it’s worth evaluating whether the sizable fees outweigh the potential tax benefits.
Agents make a lot of money selling the idea that life insurance is a great way to save for retirement. But given the considerable cost of these policies, you’re probably better off purchasing a low-cost term policy and investing in something simpler, like an IRA.