Using Life Insurance to Help Supplement Your Retirement Income

Incorporating life insurance into your client’s retirement plan can be key to them saving more.

In today’s economic environment we are learning how self-sufficient we need to become to support an extended retirement. Pressure is everywhere. Employers looking to trim costs are cutting benefits such as pensions and 401(k) matches; governments are looking to cut costs and possibly raise taxes. Behind it all is the question of whether today’s baby boomers will see all of the Social Security benefits they expected. To support a retirement, many people are increasingly realizing they need to save more. If your clients have a life insurance need, a cash value life insurance policy might be able to serve a double purpose. Types of death benefit needs might include:

• Protecting one’s family, where there is also a need to save for retirement;

• A business continuation sale where the owners might want the cash value for a lifetime purchase; or

• A key person coverage where a business might want cash value on its books in addition to the death benefit protection.

Many permanent life insurance policies have a cash value component that, under current tax law, allows policy values to grow tax free. With proper planning, a policy owner can receive some of this cash value income tax free through an approach known as withdrawals and loans. The life insurance can help fill a family’s death benefit needs pre-retirement. Post-retirement these withdrawals and loans may help supplement a client’s retirement income.

For example, Matt is a healthy 45-year-old. He has a $200,000 life insurance need but also needs to save more money for retirement than he can put into his 401(k) and IRA. He purchases a life insurance policy and commits to funding it at a rate of $500/month or $6,000 each year. Over 20 years he has paid into the policy, by way of premiums, $120,000. By the time Matt reaches retirement at age 65, and based on the assumptions in the footnote cited above, the life insurance policy has increased its death benefit to approximately $410,000 and has a cash surrender value of approximately $200,000. Matt may be able withdraw his $120,000 cost basis in the contract and then take loans of any remaining cash surrender value. The actual rates, premiums and cash values will vary based on the client’s age, underwriting classification, expenses and other factors, including the life insurance carrier and the contract that is selected.

Generally, this can be done tax free with proper tax planning. Matt may be able to withdraw or take a loan out of the policy to meet certain large expenses, or he may use the policy to help supplement his retirement income with any available cash value. Under this scenario, he also may be able to take loans and withdrawals of $19,000 per year for 15 years, or to his age 85 and still maintain a decreased life insurance death benefit. Loans and partial withdrawals will reduce the policy’s death benefit and increase the chance a policy may lapse.

Because the funds from the life insurance contract generally can be received tax free, this offers Matt certain other potential advantages. First, if we assume Matt is in a 28 percent income tax bracket, the $19,000 is the equivalent of his receiving $26,500 of taxable income. Additionally, this tax treatment allows him to do a level of income tax planning. Before Matt’s income tax reaches the 28 percent bracket, his income is exposed to taxes at what is called a graduated rate. His first tier of income is taxed at 10 percent, the next at 15 percent and so on until he reaches the 28 percent tax bracket. This is based on today’s tax rates, which may be higher or lower when Matt retires.

Because Matt has certain income in retirement that he must take, such as 401(k) distributions, or income that he will receive as a matter of course, such as dividends or interest, he can fill up these lower tax brackets with this required income. Then, he can add to his other living needs with tax-free income such as life insurance cash value withdrawals and loans, or distributions from assets such as Roth IRAs. In effect, by picking and choosing the sources of some of his retirement income needs, Matt is able to dial his tax bracket.

The following chart helps illustrate how this would work if Matt needed to receive $100,000 of income in a given year. In both of the scenarios shown, Matt fills up his lower tax brackets with income items that he is required to take. When he reaches the higher income tax brackets (here 25 percent) he has more control over how much he pays by way of taxes. In the lower example where he uses life insurance, he is able to receive the same $100,000 of living expenses, but save $7,325 of taxes in the process, a 43 percent savings over the scenario where he paid taxes on his third tier of income.

Care needs to be taken when using a life insurance policy for both death benefit protection and to help supplement income. First, the policy cannot be designed as what is defined in the Tax Code as a Modified Endowment Contract (MEC). Such a design would exacerbate your tax picture by not only exposing the received fund to taxes, but it may also impose a 10 percent penalty for individuals under age 59 ½. Additionally, clients need to work carefully with their life insurance agent to monitor their life insurance policy. Withdrawing or borrowing too much from a policy may cause a life insurance contract to fail tests that define life insurance in the Tax Code. Such failure would cause a client’s life insurance to no longer be treated as life insurance and clients will be responsible for incomes on all prior income from the life insurance policy. And, certainly, clients would only want to use life insurance as a component of a larger retirement plan or wealth transfer plan.

Life insurance can play an important role in each person’s overall family protection or wealth management. Where there is also a savings need, clients may want to consider a permanent cash value life insurance contract.

by Mark Teitelbaum, JD, CLU®, ChFC® for the Winter 2012 issue of The Wealth Channel Magazine


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