Some financial professionals have recommended life insurance policies as a retirement funding source. While it’s true that some policies can offer protection and act as a retirement savings vehicle, such a strategy might not be the most effective. Here are three alternatives.
A Roth IRA can offer a similar tax profile as whole life, but with more flexible investment and withdrawal alternatives
An annuity can offer protection in the form of a guaranteed income stream
Permanent life insurance is sometimes discussed as a way to save for retirement. Whether it’s variable, universal, whole life, or some other hybrid life insurance plan, these vehicles are sometimes touted for their tax-deferred potential and as a way to borrow money tax-free—a portion of the premiums go into an account that builds cash value along with the death benefit.
Borrowing money from life insurance may look appealing because of the tax benefit, especially if you need a loan due to a job loss or other pressing need. But when it comes to creating a life insurance retirement plan, investors may want to consider alternatives. It’s worth it to weigh the differences, for example, between investing in your 401(k) versus life insurance for retirement.
“The inherent cost of life insurance within any kind of permanent life insurance policy can become very expensive to continue to maintain,” said LaRelle Watson, product manager for The Insurance Agency of TD Ameritrade.
Sometimes the ongoing expense of a life insurance policy can eat up the investment value of the plan, he explained. Older people in their 80s or 90s sometimes let the policy lapse as it may no longer be relevant. Watson noted, however, that if the plan lapses, the tax-advantage withdrawals become taxable in the year the policy ended—and lot of people don’t realize that.
Here are three ideas on how to balance insurance needs and retirement.
Term life insurance can be significantly cheaper than permanent life insurance. Because of all the variables that come with life insurance—age, gender, health, and family history, for example—it’s impossible to say just how much cheaper, but Watson said it can be significant.
Watson explained he sees insurance as protection for people who need to guarantee certain expenses get covered, such as ensuring children can go to college or mortgages are paid off.
“If you pass away early and your (partner or spouse) loses that income, then you need some protection to make sure those expenses still get covered,” he said.
Term life insurance can cover you and your family so the kids can get through college, the house gets paid off, and other major bills are funded. With the savings you have from buying term life insurance, use that money to be diligent about your investing. Get out your budget and pay yourself first by enrolling in automatic deposits to retirement accounts such as individual retirement accounts (IRAs) and maxing out your 401(k) or 403(b) plan, or at least funding it enough to get the employer match. Have the choice of a health savings account? Put money there to help pay for medical expenses now or in retirement.
Speaking of IRAs, if you’re weighing whole life insurance versus an IRA, think about a Roth IRA. Watson explained insurance premiums aren’t tax-deductible, and although you don’t get a tax break when investing in a Roth IRA either, your tax benefit comes on the back side, when you take your money out.
Traditional and Roth IRAs have some restrictions and tax penalties when a person withdraws money before age 59 ½ that permanent life insurance doesn’t, but Watson noted the Roth IRA may be another alternative because they typically offer access to a wider variety of investment choices. “In an insurance policy, like universal or whole life, the returns are traditionally fairly low because it just pays you dividends and interest,” he said. “With variable life, those investments tend to be somewhat expensive and limited to what the plan offers.”
The idea behind insurance is protection, Watson explained, and an annuity can offer that protection by guaranteeing income in retirement. “The closer a person gets to retirement, it can make sense to look at annuities,” he said.
There are several types of annuities available, with the most basic being a single premium immediate annuity.
You give the insurance company a certain amount—say, $100,000—and the company pays you a fixed amount on a regular basis (monthly, quarterly, or annually, for example) that’s guaranteed for the rest of your life, and possibly the life of your spouse, depending on how the annuity is structured.
Although individual needs are different, people who buy annuities use them to cover fixed costs such as household expenses—utilities, mortgage or rent, property taxes, or other recurring obligations. “Annuities are designed to pay core expenses and supplement other predictable sources of income like Social Security or pensions,” Watson explained.
When it comes to retirement savings and investment strategies, you have a number of choices, and there’s no one-size-fits-all answer. But depending on your objectives and time horizon, any of these alternatives—or a combination thereof—might be right for you.
Annuities are long-term investments designed for retirement purposes. Withdrawals of taxable amounts are subject to income tax and, if taken prior to age 59½, a 10% federal tax penalty may apply. Early withdrawals may be subject to withdrawal charges. Optional riders are available at an additional cost. All guarantees are based on the claims paying ability of the insurer. An annuity is a tax-deferred investment. Holding an annuity in an IRA or other qualified account offers no additional tax benefit. Therefore, an annuity should be used to fund an IRA or qualified plan for annuity features other than tax deferral. Product features and availability vary by state. Restrictions and limitations may apply.
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Debbie Carlson is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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