Life insurance agents sell the benefits of permanent life insurance that accumulates cash value. In fact, such policies usually only make sense for individuals with a net worth of at least $11.4 million, the post-reform threshold (as of 2019) at which estate taxes kick in after death.
For almost everyone else, the best way to incorporate life insurance into retirement planning is to get the appropriate death benefit for a family that also leaves some money to allow them to take steps toward financial security.
- Almost everyone needs life insurance: Even those who die young want their spouse to be financially secure in retirement.
- Term insurance provides basic protection for a family if one of the breadwinners (or the main care-taking parent) dies; the low, fixed price frees up more disposable income.
- Employer-provided life insurance isn't always adequate.
Step 1: Buy Term
Whether someone has children and a spouse who depend on their income or on their services—stay-at-home parenting or homemaking—their financial plan should include life insurance. “It’s important for both working and non-working spouses to have life insurance,” says Kristi Sullivan, CFP, Sullivan Financial Planning, LLC, Denver. “For the working spouse, you want to have enough insurance to cover large debts (such as a mortgage), future obligations that can no longer be funded by the earnings of the deceased (such as costs for college or 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,” Sullivan adds.
Almost everyone needs life insurance, even those who die young and miss retirement: Families still want to ensure that a surviving spouse will be financially secure in retirement. The only possible exception would be a single with no dependents (including elder parents or siblings).
The least-expensive type of life insurance, considering not just out-of-pocket expense but also the amount of coverage you get for the money, is term life (aka pure life insurance) that guarantees payment of a stated death benefit during a specified term. Once the term expires, the policyholder can either renew for another term, convert to permanent coverage, or allow the policy to terminate.
Life insurance prices—and advantages—vary significantly depending on one's age, health, and policy features. For example, a non-smoking, 35-year-old New York man in good health (meaning his blood pressure and cholesterol are only a little higher than ideal) might be able to get a 20-year term policy with a $1 million death benefit for $1,030 or less per year. If the same man bought a whole life policy, a type of permanent life insurance, the premium might be $13,500 or more annually for the same death benefit.
Given these costs, term life insurance can be an ideal retirement savings tool in two ways. First, it provides the basic financial protection a family will need if one of the breadwinners dies before accumulating enough savings for the family to live on. Second, the low, fixed price frees up more disposable income to create an emergency fund, purchase long-term disability insurance, and invest in low-cost stock funds.
The best way to incorporate life insurance into retirement planning is to get the right death benefit for a family with money left over to take key steps toward financial security.
“Given the lower premiums associated with the policy, investors will have more to invest for retirement, college or other financial goals," 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.
How long a term one needs also depends on one's current age; it can be difficult to get term insurance past age 65. How much life insurance to carry depends on debt, replacement income needed, and the cost of such future obligations as college tuition.
The level of life insurance provided as a workplace benefit isn't always sufficient for a family, and the employee might need supplemental insurance using a private policy. A level-premium, guaranteed renewable, and non-cancellable term life insurance policy can give the security of knowing the insurance will be renewed each year as long as the premiums are paid. As long as the policy remains in force, the premiums will be the same every year.
Step 2: Create an Emergency Fund
The first way to put the savings from term life insurance to work is by building an emergency fund of three to six months’ expenses—or more—if someone is risk-averse or has an irregular income. An emergency fund can also head off debt after times of increased expenses or reduced income.
Avoiding debt also means avoiding paying interest: Having to pay interest, especially at relatively high credit card rates, makes it harder to recover from a setback. A financial emergency can mean temporarily stopping retirement contributions, too. The sooner someone can bounce back from a financial emergency, the sooner they can get back on track with retirement savings.
Step 3: Protect Your Income With Long-Term Disability Insurance
Even single people without children to support may still need disability insurance. In the event of serious illness, someone who lacks a spouse or other immediate family to help will especially need some sort of coverage to help pay the costs of care.
Ideally, someone takes this step while building their emergency fund. 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—which also might fall far below what one needs.
Among disability insurance policies, an own-occupation policy will cost more than an any-occupation policy but will provide more comprehensive coverage. If one can no longer work in a chosen profession—say, accounting—they won’t have to become a retail store greeter to get by; disability insurance will replace a significant percentage of the lost income.
Again, look for a guaranteed renewable and non-cancellable policy that ensures that premiums won’t increase and re-qualifying won't become an issue: The policy stays active as long as the premiums are paid.
Choosing the best disability insurance means either purchasing a policy to protect 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.”
And, of course, without an income, you have no way to save for retirement.
Step 4: Invest the Rest
Permanent life insurance policies have a cash-value component that accumulates savings and can be invested. But the insurer is making the investment choices. One has much greater control over potentially earning highest returns if they invest on their own through a brokerage. There are no high policy fees and agent commissions as with permanent life insurance, investment performance isn't tied to the life insurance company’s financial performance, and available investments aren't limited to what the insurance company offers.
Low-cost brokerage offerings often include uncomplicated index funds or exchange-traded funds. A target-date fund also adjusts a portfolio to become more conservative as someone nears retirement age.
The Bottom Line
Most people don't think of term life insurance and investing the saved money when considering how a life insurance policy can help meet retirement-savings goals. Yet for many it’s the most effective strategy.