Life Insurance is not a Retirement Plan
Recently I was asked, to weigh in on life insurance policies in general and more specifically,their place in the retirement planning process. While at first the topic might not seem directly on point for a retirement planning, many life insurance policies are sold under the guise of saving for retirement.
Should life insurance be a key part of your retirement plan? Life insurance should be a vital part of your overall financial plan, specifically, if people depend on your income (e.g. your children and your spouse). A sizable income tax free life insurance death benefit payment is the best way to maximize the chance that your dependent's standard of living is not dramatically reduced due to your untimely demise. In fact, income replacement is the number one factor couples site as a reason for purchasing life insurance.
Then the question becomes, what type of insurance should you purchase and is it a good idea to use insurance as an investment for retirement. If you listen to Suze Orman, Rick Edelman or other self proclaimed financial gurus the answer you will get is that there is no reason to buy anything other than term insurance and that permanent insurance helps no one except the agent/advisor that sold the policy. Others will argue that term insurance is a temporary fix and since in generally offers no equity it is like renting an apartment versus buying a home and that you are throwing you money away. Insurance industry legend Bob Castigione, creator of the LEAP selling system, will posit that every investment dollar that you have should be invested in permanent whole life insurance. The truth actually is somewhere in between.
When you purchase life insurance to protect your family, you'll want to be sure you buy adequatecoverage. First and foremost, you want to make sure that if you die there is adequate funds available to take care of your family financially. For many people, that means purchasing Term Insurance which is the most affordable type of life insurance. Others may still consider permanent insurance (Whole Life, Universal and Variable Universal) because they are drawn to the cash value (equity) that the policy builds over time. The problem is that purchasing the cash value insurance, however well intentioned may leave the family at risk. Let’s take an example of a male age 35 that is in good health and purchases a $1,000,000 whole life insurance policy from a (A+) rated insurance company. His premium as a select preferred rating will be approximately $10,960 per year. The policy will build cash value on a guaranteed basis and may build additional cash value based on what the policy owner chooses to do with any non-guaranteed dividends the company may pay each year. Over time, the policy will build cash value in excess of the actual premiums that were paid. But what if he dies? As Shakespeare so aptly put it, “there’s the rub”. The family will still receive only the death benefit portion (which may increase over time if dividends are paid and used to purchase additional insurance) and not the cash value/savings portion.
The same 35 year old man could use the $10,960 premium to purchase a 20 year level term insurance policy with a death benefit of more than $15,000,000. I have been in the financial services business for more than twenty years. At the insured’s funeral no one has ever asked me if the deceased had the “good kind of insurance that builds cash”. All they want to know is if there is enough to take care of the family. This hypothetical 35 year old man may opt for another strategy. Purchase a lower cost $5,000,000 20 year term life insurance policy and invest the cost savings into his company 401(k) plan. In this case, the approximately $3,000 term insurance premium would afford the individual a $7,960 cost savings. Because of the pre-tax nature of 401k investments, the man would be able to invest $12,000 into his 401(k) plan for the same $7,960 net cost. At the end of the day, he will have five times the insurance protection for his family and a pre-tax deposit of $12,000 going into his 401(k) plan. Caution: This “buy term and invest the difference” strategy only works if you invest the difference. That means either enrolling in or increasing the contributions to your 401(k) or other retirement plan. If you aren’t afforded a plan through your employer, or if you are self employed, there are other retirement investments designed for you that will give you the same net result. Contact your advisor to review their appropriateness and merits.
With the advent of buy term and invest the difference insurance companies began marketing a product called Variable Universal Life Insurance (VUL),which is a hybrid type product and accomplishes the buy term and invest the difference within one plan. Advisors point out the fact that the fact that Variable Universal Lifeallows the policy owner to choose from an array of separate accounts (mutual funds that are part of the insurance policy). They discuss the tax advantages of the policy (tax deferred growth with tax free access via policy loans). With VUL the individual takes on more risk and has potential of a higher reward in a bull stock market but will also participate in lower returns in a down or bear market. However, the internal costs associated with the policy, including the increasing cost per thousand of insurance reduces the amount of your premium dollars that are actually invested into the separate accounts.
So is permanent insurance appropriate as a retirement investment? The answer is not an easy one because of all the potential pitfalls, however, you can begin by asking the question; Do the tax benefits outweigh the costs? The costs associated with permanent polices, which are used to pay commissions, marketing costs etc. are so cumbersome that in many cases the tax benefits are mitigated. Furthermore, since after you withdrawal your cost basis from the policy, you must affect policy loans to benefit from tax free withdrawals, you run the very real risk of an IRS nightmare. If the policy lapses and there are outstanding loans, every dollar of the loans will be taxed as ordinary income to the policy owner. Imagine a situation where you are making $30,000 tax free annual withdrawals from your VUL policy for the first ten years of retirement and negative market returns, coupled with increased cost of insurance and policy loan interest eating away at the policy’s cash value cause an unintentional lapse. You no longer have insurance, but what you do have is a 1099 from the company for $300,000.
Another risk inherent in the Life Insurance Retirement Plan (LIRP) concept is the possibility that, in an attempt to maximize retirement savings, the policy will be incorrectly overfunded, resulting in the policy being classified as a Modified Endowment Contract, (MEC). Under the current law, money taken from a MEC in the form of policy or premium loans, partial surrenders, assignments, pledges, withdrawals, or loans secured by the policy are subject to income tax and possibly penalties. Once classified as a MEC, a policy remains a MEC. The policy status doesn't change even if the policy is changed, adjusted, or reconfigured as a policy that would not otherwise be considered a MEC. A policy received in exchange for a MEC is also considered a MEC, even if the policy received under the exchange wouldn't otherwise be considered a MEC. Yeesh! What a mess. The very tax advantage you bought the policy for is now permanently eliminated.
Something else to consider; although insurance plans are sold as more liquid than a retirement plan, in many cases they have exorbitant and extended early withdrawal charge that may prevent the policy owner from using the funds for 10 years or more.
But a properly structured LIRP can dilute the effect of fees by aggressively overfunding the policy. The more money that is fed into the policy, the lower fees will be as a percentage of deposits. Policies that charge per deposit fees of 6 percent are obviously not good candidates for a LIRP. The drawbacks of a using a LIRP as a supplemental retirement savings vehicle are less pronounced for high-net-worth families that have already maximized other tax-advantaged retirement accounts. The question for those clients is whether the fees associated with a VUL policy erase the program’s tax advantaged benefits. The key is that they are normally only a supplement to an otherwise robust retirement plan.
In closing, if the insured does not have a need for life insurance, the high fees associated with permanent insurance policies can limit the growth of your retirement savings. The potential tax consequences of not properly maintain a plan can be devastating.
Low cost term insurance sufficient to cover their family and business needs is a recommendation most planners should make. Maximizing the tax favored retirement investment options that are available while still having enough to live comfortablyis another. Only then should you begin looking at alternative options for investment dollars.
David Katz is the Chief Financial Officer of Gitterman & Associates Wealth Management a financial and wealth planning firm located in Boca Raton. David can be reached at 561? 826?9341 or firstname.lastname@example.org
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