The Tax Benefits of Life Insurance as Part of a Comprehensive Retirement Plan
The past few years have transformed the way many American workers approach investing for retirement. Soaring stock prices aren’t the given they seemed to be a decade ago. Financial advisors are making the most of a tough situation, coming up with creative strategies to offer clients more security and a brighter outlook for their retirement years.
The primary purpose of any insurance policy is protection, but some policies can also be used as savings vehicles with important tax savings—provided they’re used correctly. One advantage of a life insurance policy is that it is one of the few assets that pays an income-free death benefit. There are a number of other tax benefits as well, and those make life insurance worth another look as a supplementary retirement strategy once you’ve maximized any available tax-deductible options, such as contributions to a 401(k) or IRA. But not all policies are created equally, and the best plan for a single woman early in her career can look vastly different from the best plan for a married man who’s approaching his golden years. It’s incredibly important to seek the counsel of an experienced investment advisor to assemble the right components for a solid retirement plan. Go in with your eyes open and understand how the strategy works.
Life Insurance Policies
Life insurance policies are structured differently depending on their goals. Regardless of your intent, remember that insurance exists as a safety measure to pay obligations upon death. So while it may certainly make a viable investment vehicle, any life insurance policy must be viewed differently than a traditional retirement account. Some are ideal for retirement investments; others aren’t. Here’s the lowdown on the basic differences:
Term life insurance: These policies are designed primarily for protection purposes. Term insurance is generally one of the most cost effective ways of providing for loved ones due to it’s finite nature. Term insurance typically has a level premium for a duration of years, no cash buildup, and has escalating premiums after the “term” period has expired. Term policies may be most suitable for providing coverage to enable beneficiaries to remain in the family home, provide for dependent children while they are growing up, or fund a buy sell agreement for a company.
Permanent life insurance: Policies labeled as “permanent” allow policyholders to defer the taxes on any cash value growth within the policy, allowing for a possible source of supplemental benefits. As long as the policy is structured properly and the policy remains in force, policyowners can access the cash value tax-free—and that includes the gains in value—through the use of policy loans*. In their most basic form, permanent life insurance policies provide for death benefit protection just like term insurance, but if structure properly, the cash value can be used as a supplemental retirement benefit.
There are several different types of permanent life insurance – the variations depend primarily on what the cash value is invested in and the flexibility associated with the policy. With Variable Universal Life Insurance, the majority of the premiums go into one or more sub investment accounts, which are primarily accounts that invest in a diversified mix of stocks, bonds, or money market instruments. Once policy charges are deducted, any earned interest adds to the value of the policy—cash value that you can access as needed. There is also the risk of loss if the sub-account value declines. Universal Life insurance provides flexibility in accessing cash, but the cash value is invested in the general account of the insurance company and is provided a crediting rate issued by the company that typically tracks the general interest rate environment. Each of these categories includes a range of policies with varying requirements, benefits and nuances. It’s extremely important to analyze any policy with a knowledgeable financial advisor to determine how well it will fit all your needs.
Benefits For Life
Traditionally, those who purchase life insurance don’t expect to reap the benefits themselves. But smart policy selection and strategic planning allows many policies to provide tax benefits and access to cash for some smart policyowners.
Insurance in any form can be beneficial from a tax standpoint, and it was used aggressively prior to 1986. As a result, a tax reform act placed caps on the amount a policyowner could put into premiums and still get the favorable tax treatment. Modified Endowment Contracts (MEC)s were created by the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) to push back against the use of single-premium policies’ use as tax shelters. If a policy is a MEC, it changes the taxation of any money coming out of the policy.
As long as you avoid making the policy a MEC, it’s not difficult to access tax-free money if you take it as withdrawal or a loan. You may borrow against the cash value of the policy without repaying the amount you’ve borrowed until the proceeds are paid as a death benefit. As long as the amount you borrow (plus interest) is less than the remaining cash in the policy, the balances can come out “tax free”. Be careful that the loan balance does not grow so large as to exhaust all cash value in the policy, or you may have unintended consequences. The life insurance, if lapsed, creates a taxable event if the amount of loans previously received and cash value paid to the owner exceeds the gross premiums paid since inception.
In some cases, advisors will persuade clients to surrender their permanent life insurance policies in order to purchase a life annuity—a good plan as long as it doesn’t come with a large tax obligation attached. Make sure your agent is well versed in these strategies before committing to what could be a costly mistake.
Avoiding The Pitfalls
Regulations can always potentially change the playing field, but they tend to crop up only in the face of widespread abuse. It’s wise to follow the spirit of the codes rather than just the letter of the law.
Make no mistake; life insurance is a long-term strategy that should be primarily purchased because of the need for a death benefit. There are brokers who emphasize the notion that you can grab all the tax-free cash but downplay the cost side. There may be surrender charges or tax costs if withdrawals are made in the early years of a policy. Due to the costs of insurance surrender charges and the like, some policyowners are tempted to skip their premiums, fail to fund the policies accordingly or get spooked when the internal cash values don’t perform as well as expected. If the cash isn’t growing rapidly enough for those regular withdrawals, the policy won’t perform as expected.
Who Can Benefit?
For that reason, this strategy is best suited for younger people who have maxed out their 401(k) or other retirement plans and want to put more money into a long-term plan with obvious tax benefits. Those who are over 50 and haven’t taken full advantage of the retirement plans at their disposal aren’t great candidates to benefit from buying life insurance, although older professionals who are looking for additional vehicles to put additional retirement cash for 15 to 20 years down the road can find what they’re looking for with this strategy.
It’s important to ask lots of questions and really define your needs. Sometimes 412(i) plans or other qualified retirement plans include life insurance as an asset, and that can be helpful if it’s not used aggressively. This structure tends to be illiquid for the first decade.
The best way to ensure you’re choosing an ideal path is by consulting with an experienced and trusted financial advisor who understands all the ins and outs of retirement planning. For more information or to find additional resources, visitwww.burnhamgibson.com.
About Darin Gibson, MBA, CFP®, ChFC, CLU
As owner and president of Burnham Gibson Financial Group Inc., Darin Gibson is responsible for the management, strategy, business development and overall leadership of the firm. A problem-solver by nature, Gibson believes in the power of prudent financial planning, and he takes satisfaction in helping his clients look objectively at their financial situations. Throughout his 15-year career, Gibson has specialized in comprehensive financial and estate planning strategies for closely held businesses. Gibson currently manages more than $250 million in assets for individual and corporate clients. Gibson completed his undergraduate degree as well as his master’s degree in business administration at the University of California, Irvine. He holds the CERTIFIED FINANCIAL PLANNER™ professional, Chartered Financial Consultant and Chartered Life Underwriter designations. He is a Charter Member of The Center for Investment & Wealth Management Advisory Board at the Paul Merage School of Business at UC Irvine. Gibson and his wife, Ilone, reside in Laguna Niguel, Calif., with their two children.
About Burnham Gibson Financial Group, Inc.
Burnham Gibson Financial Group, Inc., is a unique financial services firm offering an unparalleled complement of best-in-class services to help provide for the full spectrum of financial and insurance needs. Darin Gibson is joined by a team of 20 financial advisors and staff who specialize in corporate services such as pension planning, executive benefits consulting and risk management, as well as financial services to individuals, including wealth management and estate planning strategies. Burnham Gibson works with corporate clients of all sizes to provide integrated financial plans and a comprehensive employee benefits portfolio, including all the resources to execute a responsible long-term plan. The planning and investment philosophy at Burnham Gibson focuses on helping clients meet goals and objectives, with an emphasis on linking their current financial situation, aspirations and lifestyle. Certified Financial Planner professionals offer objective insight and a long-term perspective. www.burnhamgibson.com.
*Policy loans and/or withdrawals are generally not subject to taxation up to the amount paidinto the policy. Policy loans abnd/or withdrawals will generally be taxable to the extent of gain if the policy is a modified endowment contract or if the policy terminates prior to death. Policy loans and/or withdrawals also reduce the cash surrender value and policy death benefit and increase the chance that the policy may lapse. Policy loans accrue interest that further reduces the cash and death benefit values. Policy loans also can be subject to tax if not paid back. The default amount would then be deemed a distribution.
Please be advised that this document is not intended as legal or tax advice. Accordingly, any tax information provided in this document is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transaction(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent tax advisor.
Securities and investment advisory services offered through AXA Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC. Annuity and insurance products offered through AXA Network Insurance Agency of California, LLC and its affiliates. Burnham Gibson Financial Group, Inc. is not a registered investment advisor and is not owned or operated by AXA Advisors or AXA Network. CFP® and CERTIFIED FINANCIAL PLANNER™ are certification marks owned by the Certified Financial Planner Board of Standards, Inc. These marks are awarded to individuals who successfully complete the CFP Board’s initial and ongoing certification requirements. Burnham Benefits Insurance Services is not affiliated with AXA Advisors or AXA Network.
PPG 66336 (1/12)(Exp 1/14)