By David R. Peters, CPA
It seems like every few years, a product comes along that evokes very strong opinions from the financial community. Reverse mortgages, variable universal life insurance and long-term care insurance come to mind. People seem to either love them or hate them, with little room in between.
In more recent years, life insurance in retirement planning is getting increasingly more attention from financial advisors. While some financial advisors have praised the ingenuity of using life insurance in this unique way, others have called those who use this strategy irresponsible, overly aggressive or sometimes much worse.
Now I know what you are thinking. Life insurance plans have been around forever, and the idea of using them for retirement funding is not exactly new. I had a conversation with a prospective client recently who has been using life insurance as part of his retirement planning since the early 1990s. However, given the recent shift to more defined contribution plans and the attention given in the media and major publications to shortfalls in retirement savings, more people are turning to financial advisors for creative solutions on how to plan for retirement. Hence the rise of life insurance.
The strategy usually goes something like this. The client buys a permanent life insurance policy — normally universal life or variable universal life. The policy is funded (that is, overfunded) by amounts over and above the premium amount. The policy builds up cash value very quickly and becomes self-sustaining after only a small number of payments. Once the cash value is high enough, distributions may be taken from the policy. Loans may be taken as tax-free distributions that never have to be paid back.
Withdrawals from life insurance policies may also generally be taken tax-free to the extent of basis. Even partial surrenders may be taken as a tax-free distribution, as long as basis is not exceeded.1 (Copeland & Littell, 2013). Regardless of the method used, the client takes cash out of the policy. This cash flow is in addition to any cash that may be available through traditional means, like 401(k) or individual retirement account (IRA) distributions. The accumulated value of the policy does decrease with each distribution, but utilizing this strategy, the client has achieved the goal of supplementing his or her retirement income using a life insurance policy. The client has also incurred little or no tax liability in the process. All in all, not a bad result!
So why would someone look to use life insurance in retirement planning? Flexibility. While traditional retirement vehicles such as the 401(k), Simplified Employee Pension (SEP) and IRA all have annual contribution limits imposed by the U.S. Internal Revenue Service (IRS), life insurance plans typically have no limits. The only real limitations a person faces are the underwriting criteria of the insurance company. Used correctly, life insurance provides a way to supplement retirement income beyond what may be provided by typical retirement accounts. For high-net worth individuals who may truly need a much higher level of retirement cash flow, life insurance can provide a way to meet retirement goals in a tax efficient way at low funding levels.
However, those who oppose the use of life insurance in retirement plans will be quick to point out that this result is the ideal state and largely ignores the many risks inherent in the strategy. First, the
appealing tax benefits are contingent on the policy being considered a true life insurance contract by the IRS. If the policy is classified as a modified endowment contract (MEC), the tax benefits disappear. The withdrawals are generally taxable in full, as the tax law assumes that the distribution is “income first” —a far different result. It should also be noted that if a policy is classified as a MEC, it never can go back to being a life insurance policy.
A second issue to consider is the inherent risk of lapse. A policy can lapse, if the loan amounts are high enough. In the case of variable universal life policies, in which policy value is linked with the market, this risk increases in the case of a sudden crash in the market.
Finally, fees may come into play. Depending on the policy design, fees on universal life and variable universal life insurance policies can be substantially higher than if a client were to simply invest in the open market. This result is certainly avoidable, but it requires the client to evaluate all possible options — not just life insurance products.
While these risks are substantial and should not be ignored, the flexibility provided by these policies should not be immediately written off either. Just like any other risky financial product, life insurance can have a place in retirement planning under the right circumstances for the right client. If a client has maxed out all other retirement vehicles, still needs retirement income and can tolerate the inherent riskiness of the strategy (both mentally and financially), then life insurance may have a place in his/her retirement plan.
However, as financial advisors, we should always remember that life insurance is not primarily a retirement vehicle, and that the situation described above is rare. As a recent U.S. News & World Report article suggests, we should always evaluate the use of life insurance against all other retirement planning alternatives2 (Wohlner, 2013). For example, a client making $70,000 per year who has not yet maxed out on their 401(k) may do better contributing more to the 401(k) before considering life insurance as a retirement planning vehicle.
The key for financial advisors remains evaluating each client situation individually within its own unique context, so that the client does not take on more risk than necessary. In this way, knowing when to apply a life insurance strategy to retirement planning is just as important as knowing when not to apply it.
David Peters, CPA, is the strategic relationship manager and financial advisor for Carroll Financial Inc., in Charlotte, N.C. He is also an adjunct professor in accounting, insurance and ethics, a doctoral student in financial planning and sits on the Disclosures Editorial Task Force. Website: www.carrollfinancial.com
Works Cited
1. Copeland, C., & Littell, D. A. "The Top 4 Benefits of Using Life Insurance in Retirement Planning." Annuity Outlook Magazine. Nov. 1, 2013. http://tinyurl.com/hfs8k6n. 2. Wohlner, R. "Is Life Insurance a Retirement Investment?" U.S. News & World Report. June 12, 2013. http://tinyurl.com/k6cpr7y.
The information discussed herein is general in nature and provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Nothing in this article constitutes an offer to sell or a solicitation of any offer to buy any type of securities.
Registered Representative of and securities offered through Cetera Advisors Network, LLC, Member SIPC/FINRA. Advisory services offered through Carroll Financial Associates, Inc., a Registered Investment Advisor. Carroll Financial and Cetera Advisors Network, LLC are not affiliated.