Can you turn your life insurance into tax free retirement income?
Life insurance should be a part of many people’s retirement plans. However, it should never be your entire retirement income strategy. There is an array of people pitching crazy tax-planning strategies using life insurance that are likely not appropriate for those making less than $500,000 or so per year. That being said, there are a few ways that many people can benefit from life insurance without actually having to die first.
Keep reading as we share some insight on utilizing life insurance for your retirement and path to financial freedom.
Can You Help Fund Your Retirement With Life Insurance?
Life Insurance proceeds can help the surviving spouse fund their retirement if the other spouse dies prematurely. Cash Value Life Insurance can also be used to generate tax-free retirement income. Strategies like Infinite Banking or the Rich Person Roth (which I originally wrote about for Forbes in 2018) can be valuable when used properly and obscenely expensive when used inappropriately.
How Does Life Insurance Typically Work?
Old school life insurance: You buy a life insurance policy, pay premiums, and eventually, you die. Your beneficiary gets a death benefit. A common example of this is the free $50,000 term policy many people get from their employers.
In contrast, new life insurance policies offer several benefits you can use and benefit from while still alive. These benefits include things like cash value, living benefits, and tax-free lifetime income options. It may sound wild, but you could potentially retire from a life insurance policy. As a fiduciary financial planner, I must point out that few people are funding a life insurance policy in a way that would allow them to retire from their life insurance alone.
Can Life Insurance Replace Typical Retirement-Planning Strategies? (Think 401k, IRAs, Pension Plans, or Annuities)
If you need life insurance to protect your loved one, using cash-value life insurance to subsidize your retirement income can be a good strategy. However, run and run fast if someone tells you to stop contributing to your 401(k) or other retirement accounts to buy a huge life insurance policy. They are likely just looking to earn a huge commission. In many cases 100% of your first-year premiums, or more, could go to fund commissions to the agent who sold you your life insurance policy.
Generally speaking, the cost of investing via life insurance will be much higher than utilizing a 401(k) or an IRA. Also, life insurance would require ongoing premiums to be paid for the life insurance and growing the cash value.
For best results, the Rich Person Roth strategy for Cash Value Life Insurance should be used after all other easier-to-use strategies have been maximized. Similarly, the Rich Person Roth tax-planning strategy gives the most value and tax savings to those in the highest income tax brackets and/or those living in high-tax states like California. We will go more in-depth on how the Rich Person Roth generates tax-free retirement income below.
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How Can You Utilize Term Insurance?
Term Life Insurance is best when you have a specific financial need you need to cover for a specific amount of time. For example, if you just purchased a new home with your partner, and one of you couldn’t afford the entire mortgage on their own. In this scenario, each of you may want to consider buying a 30-year term policy to cover some or all of the mortgage.
Life insurance can also bring peace of mind to parents, knowing that if the worst-case scenario happens, their family will still be okay financially.
What Are The Pros And Cons To Including Life Insurance In Your Retirement Planning?
Life Insurance should not be your retirement plan. Still, it should play a role in your retirement planning, especially now that more people are carrying mortgages or even student loans into retirement. Life insurance can increase the odds that your widow (or widower) will be able to maintain their standard of living throughout retirement.
Newer life insurance policies with living benefits can help ensure you have money for end-of-life care. Think Long-Term Care or in-home health care. Likewise, life insurance can be used to replace the lost Social Security income when one spouse passes.
3 Ways To Utilize Life Insurance For Retirement Without Dying
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The Rich Person Roth Tax-Free Income Strategy
I like to call the strategy of generating tax-free income from life insurance the “Rich Person Roth.” Typically, this tax-planning strategy only benefits people with incomes that make them ineligible to use the Roth IRA. Now, we need to add the caveat: people who make too much to contribute to a Roth IRA and have already maxed out their Roth 401(k), which doesn’t have an income limitation (beyond being able to contribute $30,500 in 2024 if you are 50 and older).
When using the Rich Person Roth Strategy, if you set up a cash-value life insurance policy correctly, you could contribute any amount you want each year, and the cash value would be treated basically like a Roth. That means your contributions grow tax-free and come out tax-free, too. The bottom line is that you are using Life Insurance for retirement income. Again, if you have access to a Roth 401(k), you should contribute here first.
Life Insurance Benefits You Don’t Have To Die To Use
There is an array of health-related life insurance living benefits and riders that can be added to your policies at different insurance companies. The three most common benefits cover Terminal Illness, Chronic Illness, and Critical Illness coverage. Other policies may come with benefits that cover long-term care costs often covered by the chronic illness rider.
I won’t bore you by listing all the diseases and ailments that may be covered. Think heart attack, stroke, or cancer. Let’s hope you have a long healthspan and perhaps just kick the bucket peacefully in bed at 104.
When talking cost, it can be much more expensive to suffer for years with a chronic illness versus simply passing away too soon (which has some definite downsides, too).
No one buys insurance hoping to get sick but rather to diminish the potential for financial devastation that could occur if you do become ill, particularly later in life. Since health insurance can’t do it all, these living benefits will help you have more options to cover costs that could grow exponentially. This coverage will mean that life insurance protects your other income during retirement.
Personal Pensions Via Life Insurance
With proper planning, you can also strategically use the cash value as a personal pension. Some policies will have a “lifetime income rider.” If you plan ahead and stash enough cash into the policy, you can create your very own pension that comes out tax-free—taking tax-free income from your life insurance for retirement.
The great thing about this personal pension strategy is you don’t need to be self-employed to contribute hundreds of thousands of dollars per year to a tax-advantaged account. If you are a business owner or self-employed, this strategy would be implemented only after maxing out your 401(k) and Cash Balance Pension Plans.
The person pitching life insurance to you may make an appealing case to use the Cash Value to fund your entire retirement income. One hundred percent tax-free retirement income sounds great. The problem is that you would likely pay substantially more taxes during your working years, increasing your overall income taxes over your lifetime.
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