Beware of Funding Retirement with Life Insurance
By Carl Lachman, CFP®, MBA
It Sounds Like a Perfect Plan!
It is possible to put a lot of money into part of a specific type of life insurance policy, let the money grow tax-free for years, then take the money out tax-free when you retire. No income tax. No capital gains tax. This sounds like the perfect plan to pay for your retirement.
It’s Used by the Wealthy!
Like many of our clients in Fullerton, California, you may have heard about this “best-kept secret.” You may have been told that “savvy millionaires and billionaires” have used this strategy “to grow their wealth safely, provide income in retirement, and avoid taxes.” You may have heard that it is a “legal, low-risk strategy that is approved by the IRS and state regulators.” All of these points are true, but they do not tell the whole story.
Consider the Source
As with every area of your life, when someone is giving you advice, you need to consider why they are giving it to you. If you are being told that life insurance is the best solution for funding your retirement, who is telling you? What will they gain if you go along with their advice?
Chances are that the person telling you to buy life insurance for your retirement … works for an insurance company. There is nothing wrong with working for an insurance company, but can this person be counted on to give you professional advice that is free of bias and conflicts of interest?
How Do They Get Paid?
The next question you need to ask of anyone that is giving you advice is “How do they get paid?” Life insurance companies are represented by licensed agents, but licensing is not always what it seems. It is not a way to determine who the good guys and bad guys are, but rather just a way to determine who has met the minimum requirements for being able to sell insurance.
Insurance agents are licensed to sell and receive a commission for their sales. If they sell an insurance policy, they get paid. They are not fiduciaries, and thus, they are not required by law to put your interests before their own.
A better way to get advice is to consider a registered investment advisor. These professionals (like me) typically give comprehensive financial planning advice and manage your investments.
They are legally required to follow the fiduciary standard, putting your interests before their own interests. And, they are not paid by commission, but most are instead “fee-only,” which means they charge their clients an annual fee and don’t get paid in any other way.
How Does It Work?
Some life insurance policies allow cash that is paid to the insurance company above the necessary annual premium to build up and earn interest. In the case of this insurance/retirement tactic, you pay thousands and thousands of dollars above the premium.
This cash builds up in the policy far above the annual cost of the policy. When this happens, the insurance company pays you dividends or interest, so the cash in the policy grows as a sort of investment. With certain life insurance policies, if you put in enough cash and it grows some, you could potentially have a million dollars or more in the policy by the time you retire.
When you do retire, you can start taking cash out of the policy in the form of a loan to yourself. You can keep taking money out of the policy as long as you want, whenever you need it, and it is just a loan to yourself.
The only limit on how much you can take out of the cash balance is the amount of the policy. So, if you have a $1.5 million policy on your life and there is $1.2 million of cash in the policy, you can take almost all of the $1.2 million of cash out as a loan and spend it any way you want.
When you eventually die, your $1.5 million will pay off this $1.2 million loan and leave your heirs about $300,000 in cash.
The cash went into the policy, it was never taxed as it grew, and then you took it out without paying any taxes, since it was a just a loan. Ultimately, your loan is paid off when you die with the life insurance part of the policy. It seems too good to be true, but it is actually all true and possible.
What Are the Costs?
This special life insurance policy does not come cheap. First, the premiums are typically thousands and thousands of dollars every year. If you miss one of these premium payments, you might lose the insurance policy and potentially lose some of the cash you have built up in the policy.
Second, there is the opportunity cost of locking up high cash contributions. These sorts of policies require you to put in very large contributions of cash each year for a certain number of years. If you miss one of those large contributions, then the benefits of the policy are often lost. You have lost flexibility with the money. You are making a permanent, long-term decision that is hard to change without losing money in the future. If you change your mind, there will be very high surrender penalties and fees.
Third, the interest and dividends paid on your cash in the policy are usually low compared with what you could earn elsewhere. Your cash will earn below-market rates in the policy. The interest you earn may be relatively safe with a good insurance company, but you could almost always earn more interest on your money without the need of locking the money up with an insurance company for a long time.
Fourth, with a little more risk, you can probably earn a lot more on your money if you invest it in a diversified and conservative manner.
Why Get Life Insurance?
The reason to get life insurance is to insure a life. For risk management. To protect the people that you care about if you die unexpectedly.
A life insurance policy can help replace the income that your loved ones are counting on you to provide. And, a life insurance policy can pay off debt, your funeral costs, and future education costs for your child. But, usually, the risks associated with your untimely death are going to be concerns only until your kids are on their own or you have enough to retire. After those things happen, you probably don’t need life insurance.
Because with these risks it is possible to figure out about how many years your life needs to be insured, it almost always makes more sense to buy lower-cost term life insurance for just the number of years (the term) that you need it. There is no need to pay more for a universal or whole life insurance policy that does the same thing.
First Contribute the Max to Retirement Accounts
Most people do not contribute the maximum amount the law allows them to contribute to their 401(k) or IRA retirement accounts. Yet, these are usually the first and best option for retirement savings for most people. Until you contribute the legal maximum to these sorts of tax-advantaged, tax-deferred, or tax-free (Roth) retirement accounts, you should not consider any other plans for retirement savings, such as using life insurance or annuities for retirement.
What Is the Big Picture?
It is easy to hear a pitch for what seems to be a perfect financial solution but forget that it must be considered in the context of your whole financial situation. The big picture counts. How does this solution fit into your total financial plan?
If you have a fee-only financial advisor and investment manager, they will help you put this new idea in the context of your total financial life. There is a chance it will make sense, but more often than not, there will be a better way to get the biggest gain from your investments and have financial security.
Hiring a financial advisor that works for you alone, rather than being motivated to sell, is one of the best financial decisions you can make. A good source for these sorts of financial advisors in your area is to look at the National Association of Personal Financial Advisors (NAPFA) website at https://www.napfa.org/find-an-advisor.
Schedule a 15-minute discovery call with a fee-only financial advisor to discuss your personal situation.