Creating Retirement Income Using Life Insurance. Your life insurance can provide key benefits while you're still alive — here's how to incorporate your policy into your retirement income. #CentSai #lifeinsurance #personalfinance #moneymanagementThe primary purpose of life insurance is to create a lump sum of money upon the death of the insured. Purchasing life insurance without having that need for capital upon death rarely makes sense.

The reason for this limitation is cost. Life insurance policies have costs that other accumulation vehicles do not have; they will lose in a straight accumulation competition time after time. But life insurance also has some unique features that can sway the competition in its favor, in some circumstances. Its ability to provide tax-free income in retirement is one of those features.

Life Insurance as an Accumulation Vehicle

Permanent life insurance policies accumulate cash value; term policies do not. Term insurance is not appropriate to use to build an income stream — there’s nothing to generate the income from.

Permanent life policies have different risk-reward relationships, and correspondingly, different levels of potential return. They all grow cash value tax deferred. Whole life is the most conservative of the forms of permanent insurance. It is stodgy in its accumulation but is robust with guarantees.

Your investment cannot decrease in value due to anything that happens in the market — it is completely insulated from market performance, providing a nice counterbalance.

Universal life comes in several forms: traditional universal life, variable universal life, and indexed universal life. Universal polices are not guaranteed at the same level as whole life, but tend to have greater accumulation potential and a lot more flexibility.

Universal life works like annual renewable term with an investment component. It is more complex than whole life, in part because it is unbundled, you see all the cost components. The insurance rate, typically expressed as a cost per $1,000 at risk, increases with age.

Check Your Rates

The actual cost may or may not increase, depending on investment performance. If the investment side performs very well, the amount at risk decreases in a level death benefit policy. Universal life generally has only one investment account, a fixed account that earns at least a minimum guaranteed rate of interest.

Variable universal life is a form of universal life insurance with a far more robust investment component. It has all of the same features as traditional universal life, with the addition of a number of other investment options.

The investment side, from a policyowner’s perspective, is much like the investment side in a retirement plan in which there are a number of options to choose from and the policyowner can make changes as they see fit.

The accounts are not generally the mutual funds and ETFs they are used to, but sub-accounts used within insurance products. They often have higher average fees than comparable non-insurance product funds.

Variable universal life has a great deal of flexibility with the potential to achieve market-based investment performance. The variable investments are not guaranteed and the policy can lose money in the markets.

Indexed universal life insurance allows investors to obtain a degree of market-based investment performance without incurring market risk. Indexed universal life has an investment account whose performance is tied to a market index, but the funds are not invested in the market.

The index serves as the base for which returns are credited to the policyholder. The policyholder may receive only a portion of the gains in the index, or may have other performance sharing with the insurance company wherein they do not receive all of the return’s up side.

Losses however, are generally limited. Indexed universal life allows the investor to get a portion of the market’s upside while avoiding its downside completely.

These four basic types of cash value insurance can all be used to fund retirement income. The universal polices offer greater return potential than traditional whole life, and also generally have greater flexibility. Whole life’s primary advantage is its guarantees.

Check Your Rates

Accessing Income from Cash Value

When selecting and designing a policy for retirement income, there are different objectives than using the policy solely to fund a death benefit. If the policy’s sole purpose is death benefit, cash value accumulation is secondary to lower premiums; the lowest premium across time is the most efficient in creating the death benefit.

If the policy’s purpose is to create a tax-free stream of income in retirement, premiums should be paid at the maximum level that preserves the policy’s tax advantages. Putting in too much money can cause the policy to become a modified endowment contract, and the ability to make tax-free withdrawals doesn’t exist for those policies.

Permanent life insurance, like other investments, has a cost basis. The cost basis for a permanent life policy is the sum of the net premiums paid minus any prior surrenders. Net premiums are generally your total premiums less any dividends paid by the policy, as dividends are a return of excess premium.

The policy’s basis is available to the policyholder tax free through partial surrenders of the policy.

A partial surrender reduces both the cash value and the death benefit, leaving less to your heirs. Partial surrenders are normally available from any universal policy and many whole life policies.

As an example, if you had paid $10,000 per year into a permanent policy for 10 years, and the policy had not received dividends and you had not made any other surrenders, you would have a basis of $120,000 available as tax-free income. And it doesn’t stop there.

Visit Site

Once you have surrendered the basis, you can still access tax-free income through loans. You can borrow against the cash value, and the loan proceeds you receive are not taxable to you. Ultimately the death benefit your heirs receive will be reduced by the outstanding loans. There is a big caution that goes along with this.

The loan distributions are tax free as long as the policy stays in force. If the policy is allowed to lapse, the loans are treated as distributions and you may have tax consequences.

If you had already surrendered the cost basis, you would most assuredly have tax consequences. Retirement-income life insurance is a very powerful tool and like other powerful tools has to be used properly. You can’t take all the money without tax consequences.

Comparing Retirement Income Life to Other Options

Retirement-income life insurance is not for everyone. People who get employee matching on their retirement plans and tax deductions on their retirement plans should generally take full advantage of those. Once those options are exhausted, people who have a legitimate insurance need may find retirement-income life a viable strategy.

Using life insurance as a source of income in retirement can allow the retiree to manage distributions from taxable accounts to avoid taxation of Social Security benefits in some situations.

Retirement-income life insurance is not subject to required minimum distributions; you chose when and if to take distributions. For some retirees, retirement-income life provides a buffer against taking withdrawals from market-based accounts during down periods.

During retirement, order of returns matters; a significant down period early in retirement can create financial hardship later.

A source of non-market-based funds is an essential part of distribution planning.

Life insurance has expenses. Many financial talking heads suggest only purchasing term insurance and investing the difference. This presumes you will have no need for the death benefit later in retirement, and neglects the benefits of tax-free income for higher income retirees.

Life insurance as a retirement-income strategy is not for everyone, but it is very beneficial for those whose situations make it appropriate.

Check Your Rates

  • Have a question about your personal finances?
    Send it in and it could be the topic of an upcoming column!
  • This field is for validation purposes and should be left unchanged.