Life insurance has many uses. The primary purpose of most life insurance policies is to provide financial security to loved ones in the case of an untimely demise of an income earning member of a family. Many people may not realize that life insurance can also be useful as an investment to save for retirement.
Permanent forms of life insurance have cash values. When the policies are structured and funded properly, this cash value will grow internally, resulting in a net gain to the policy owner. Over time, the owner can make far more money than they put into the policy. Different types of life insurance grow the cash value in different ways, and each can be a very useful, albeit with different risk profiles, for a retirement savings account.
The safest and most predictable form of life insurance that can be used to save for retirement is whole life insurance. This is what most people choose, because of the guarantees regarding policy value made by the insurance company. People may also use variable universal life insurance, and sometimes universal life insurance, as a retirement investment as well (though it is illegal for insurance companies to sell a universal life insurance policy as an investment).
The Advantages Of Life Insurance For Retirement Savings
Life insurance provides some distinct advantages over other retirement savings methods. While not without trade-offs (generally slightly lower expected return compared to the stock market) the advantages may make life insurance exceptionally more valuable for some clients.
Life Insurance Coverage While Saving
While permanent life insurance policies will make money for their owners, they also provide coverage for the purpose they were created. If the insured person passes away (an income earning person), the policy will pay out the face value, regardless of the amount of cash which has accumulated. Life insurance coverage can support a families living expenses or fund a spouses retirement, so this benefit is extremely valuable to the insured, the owner, and their families. With the death benefit it pays, life insurance can safeguard a retirement in ways that a brokerage account can not.
The Guaranteed Nature Of Whole Life Insurance
Whole life insurance policies all have minimum grantees. This means that the money put into the policy is guaranteed to be present or grow no less than on the signed illustration. While most policies far outperform the minimum guarantees (dividends are not guaranteed but are basically always paid by major insurance companies), the minimum cash value guarantees provide a safety net for clients that other types of retirement savings account do not afford. This is a very valuable feature for owners, especially those who are averse to risk.
Withdrawals are Taxed FIFO
There is a tax advantage to taking withdrawals from life insurance policies. The first dollars out of the contract are not taxed (excluding modified endowment contracts). This is because with life insurance, the cost basis is reduced by withdrawals before any gains are realized. In most other types of retirement savings accounts, the gains are realized with the first money out of the contract. This makes life insurance potentially more tax efficient for owners to take retirement income.
How To Use Life Insurance As A Retirement Savings Account
Different kinds of life insurance build cash values in different ways, but no matter which type of policy you ultimately choose the goal is the same; to make money with the policy, and to use at least part of that money to fund retirement expenses. It may sound odd to some people that life insurance can actually make money, but it is actually the intent of almost every permanent life insurance policy to have a positive return on investment.
The Best Results Come From Funding Above The Minimum
Minimum allowable premiums will differ based upon the type of life insurance, but basically someone funding a policy at a minimum level is paying the cost of insurance, and not much more. A whole life insurance policy will still make money over a long period of time, but a variable universal life insurance and universal life insurance policy probably will not. For best results, owners need to put more money in their policies than the minimum amount required to pay the cost of insurance.
A whole life insurance policy started at a young age can still be a very effective retirement savings tool, and it will still make money even with lower payment amounts relative to the cost of insurance. For people who do not start their life insurance policies at a young age, the idea is to build the cash value as fast as possible. Higher cash value’s mean higher dividend payments for whole life insurance policies. For universal life policies and variable universal life policies a higher cash value means more potential for a high return. If you are going to use life insurance to fund a retirement, you are going to need to build the cash value. The faster you build it, the higher the potential return of the policy.
Whole Life Insurance- The Best For Retirement
Whole life insurance is really the best form of life insurance that can be used as a retirement savings account because the value is backed by the insurance companies cash reserves. If a client chooses life insurance as a retirement investment vehicle, they do so because of the relatively high rate of return given the safety of the investment.
The life insurance company makes guaranteed minimum guarantees regarding the growth of the cash value, and most often this is greatly exceeded with dividend payments. State governments also guarantee the cash value (up to a certain amount differing by state).
The real value of whole life insurance policies as an investment is that they provide an alternative asset that fits into the fixed income side of a total investment portfolio. Basically whole life insurance functions as a fixed income instrument that makes regular payments in the form of dividends.
Using Dividends Wisely
Dividends can be used in multiple ways. Policy owners have the choice of using them to offset premium due, purchasing additional paid up insurance, or as payments paid directly to the owner. The right choice differs depending upon the circumstances, but the wise policy owner will reinvest the dividends back into the policy during pre-retirement years. They then have the ability to let the dividends continue to grow the policy during retirement, or even taking the dividends as payments which sometimes can fund a retirement all by themselves. The compounding power of dividends greatly increase the total return to the policy owner.
Options During Retirement
Once retirement is reached, and the owner is ready to take a benefit from their policy, there are multiple ways to extract income from the policy. As previously discussed, the owner can take dividend payments directly to them each year. With a large enough policy, these payments can provide for living expenses without touching the principal balance of the policy. More commonly, the owner will need to take some of the excess cash value from the policy. This can be accomplished through loans or withdrawals.
Again whether a loan or a withdrawal is most appropriate depends upon each individual circumstance, but there are some important differences to keep in mind. A loan will accrue interest if not paid back, and the interest goes to the insurance company, not to yourself. A withdrawal permanently decreases the face value of the policy, while a loan does not. Reducing the face value also reduces the cost of insurance, while taking a loan does not reduce the insurance costs. A policy with an outstanding loan upon the time of a claim will have the loan amount deducted from the face amount, so most people are better served to take withdrawals rather than loans.
Some people may even surrender the policy completely, as the life insurance coverage is not really needed anymore. If the policy is surrendered, the owner gets all of the cash value (assuming no surrender charges remain) paid directly to them. On this, only the gain is considered taxable.
How Other Types of Policies Are Used
Universal life insurance and variable universal life insurance policies are also sometimes used for funding retirement accounts. Universal life insurance pays a set interest rate on any cash value in the policy. The interest rate is calculated by the life insurance company and adjusted annually.
A variable universal life insurance policy invests any cash value in variable sub accounts, the sub accounts essentially being mutual funds. The owner has the ability to set the allocation that they like, as long as they choose from the available funds. A variable universal life insurance policy is a kind of hybrid that combines the unique benefits of life insurance with the upside of a brokerage account. The disadvantage is higher fees, and there are no guarantees regarding cash value. If the market drops, the owner will lose their investment.
Both of these types of policies have very flexible payment structures. The owner is only responsible for covering the cost of insurance, they do not necessarily need to accumulate a cash value for the policy to stay in force. Contrast this to a whole life insurance policy, and an overlooked benefit of whole life insurance is that the required premium payments essentially force the owner to accumulate a cash value.
While a variable universal life insurance policy or universal life insurance policy may be appropriate for some clients, generally a client is better served to buy term life insurance and invest the difference, or to use a whole life insurance policy for retirement savings.
Life Insurance is a Solution
Life insurance provides a surprising range of products and solutions as a retirement savings vehicle. With unique benefits and a wide array of products and structures, chances are life insurance may aid your retirement investment.