Life insurance is typically not thought of as an investment for retirement. But many permanent life insurance policies have decent cash value growth, similar tax benefits, and no contribution limits. How does life insurance compare to a Roth IRA for retirement savings?
In general, life insurance is not the best primary option for retirement savings due to the high fees in the contract. But for those who have maxed out their 401k and individual retirement account (IRA) contributions, a permanent life insurance policy may offer an additional tax-advantaged savings account.
However, not all permanent life insurance is created equal for accumulating savings.
In this post we will compare life insurance to Roth IRAs for retirement savings. We will also give guidance on the type of insurance product that is best suited for use as a retirement savings vehicle.
Key Takeaways:
- In general, a Roth IRA is a better retirement savings vehicle for most people.
- Permanent life insurance shares many of the same tax advantages of a Roth IRA without any of the eligibility or income limits.
- However, permanent life insurance is expensive and comes with high annual fees and limited investment options.
- Life insurance can be a good supplemental source of tax-advantaged savings after your 401k and IRAs.
Life Insurance Vs. Roth IRA
You are likely familiar with a Roth IRA. It is a retirement plan that you open and contribute to with your own money. Roth IRAs are heavily recommended due to the contributions being after-tax but growing tax-free and allowing for tax free withdrawals in retirement.
However, life insurance can have similar mechanisms for retirement savings. Permanent life insurance has a cash value component that will grow based on the markets. You pay premiums with after-tax money, it grows tax-deferred, and there are tax-advantages for when you take withdrawals.
Which is better?
In general, Roth IRAs will be the better option for saving for retirement. However, this doesn’t mean life insurance can’t be useful. Life insurance also allows for tax-free growth in your cash value and tax-advantaged withdrawals. Additionally, life insurance has a death benefit that is typically tax-free, which can be a massive return if you are to unexpectedly pass away.
What are the pros and cons of using life insurance vs a Roth IRA?
Benefits of Life Insurance over Roth IRA
Life insurance does have some advantages over a Roth IRA for retirement savings.
First, there is no federal contribution limits on life insurance. Roth IRAs have a set maximum annual contribution which is $6,500 in 2023 ($7,500 if older than 50).
Life insurance does have limits to contributions due the IRS rule around when a policy is no longer an insurance contract but a modified endowment contract (MEC). MEC rules were put in place to prevent people from buying negligible insurance amounts and putting so much cash into the policy that it is essentially a tax-haven investment.
But with proper planning, you can purchase a large enough face amount that you avoid being a MEC awhile making your desired contributions.
Second, there are no income limitations to life insurance. The Roth IRA has income cut offs where you make too much money to contribute. These limits are $153,000 for single filers and $228,000 for joint filers in 2023.
Third, life insurance avoids probate. Unlike a Roth IRA which is always included in your estate, life insurance death benefits pass to your beneficiary automatically. This is helpful for estate planning.
Fourth, there are no required minimum distributions (RMDs) on life insurance. RMDs are set by the IRS to ensure that retirement money is used. Roth IRAs typically avoid RMDs, unless they are inherited by non-spouse beneficiaries. In that case, the Roth needs to begin being distributed within a year. Life insurance avoids the headache.
Fifth, there are many different types of permanent life insurance with differing levels of volatility and downside protection. For example, an indexed universal life policy has a return between a cap and a 0% floor and depends on equity markets. This lowers volatility and limits market losses. Index variable universal life (IVUL) is similar but allows for more upside in exchange for taking some downside risk.
Lastly, you get the death benefit protection. If you buy a $500,000 life policy and die before paying $500,000 in premium, your loved ones will receive the benefit. A Roth IRA only passes along the amount you contributed and any capital gains/losses.
Disadvantages of Using Life Insurance Over Roth IRA
Despite the benefits listed above, there are some large disadvantages to using life insurance for your retirement. The biggest disadvantage is the high fees in life insurance contracts. A significant portion of your premium goes towards paying fees on your life insurance policy. Then there are continuous fees on your investments and for the insurance coverage. These fees will be a drag on your cash value growth.
Second, you have limited investment options in life insurance. When you put money in a Roth IRA, you can invest in nearly any asset in the investible universe.
Third, returns in life insurance policies tend to be lower. This is driven by the fees, the limited investment contracts, and the type of policy you have. Some permanent life insurance (whole life and guaranteed universal life (GUL)) has set bank CD-like returns. Others have capped upside (index UL). These products will have less volatility and limited downside, but that comes with less potential growth.
Lastly, Roth IRAs have more tax advantage since they are never taxable after you contribute. Life insurance has tax advantages, but not quite as beneficial as a Roth IRA.
Life Insurance Retirement Plans (LIRPs)
Life insurance retirement plans (LIRPs) are a specific way to use life insurance to supplement your retirement income. In a LIRP strategy you ‘overfund’ your policy as much as possible to grow the cash value.
When used correctly, LIRPs can mimic the tax benefits of a Roth IRA. You pay your premiums with after-tax money, don’t pay taxes on any withdrawals after 59.5 years of age, and capital gains are tax-deferred.
There are specific life insurance products offered by insurance companies for the LIRP design. These policies tend to have fee structures with lower upfront fees that allow for more cash value growth. This allows for people who overfund to pay lower overall fees and grow their cash values higher.
With LIRPs, you want to overfund the contract. This means putting in as much cash as possible to drive up your cash value. In a properly designed life insurance product for a LRIP strategy, the fees taken out of the contract will be small.
[Professor B.T. Effer Note – It is important to understand one crucial aspect of permanent life insurance, your death benefit is your death benefit. If you have a $500k death benefit, when you die the insurance company pays out $500k. The payout doesn’t change if you have $100 or $200,000 in cash value. Since the insurance company funds the difference of the death benefit and your cash value from its own money, the more cash value you have, the less fees the insurance company needs to charge you. Said another way, the higher your cash value, the more of your payment can go to building your cash value.
This is why you want to overfund a policy for retirement saving purposes. It lowers the fee you pay and increases your cash value account growth.]
Using Your Cash Value To Supplement Retirement
You purchased a permanent life insurance policy and overfunded it to grow a tax-advantaged cash value account. Now what?
When you get to 59.5 years of age you can start to use your cash value if you choose. There are many ways to access the liquidity in your life insurance policy.
The simplest way is to withdraw your cash value as you need it to supplement your retirement income. But you can also fully surrender the policy and take the cash value as a lump sum. Or you can annuitize the cash value and have the insurance company turn it into a stream of cashflows for you.
Alternatively you can take a loan against your policy.
Each of these options have pros and cons. Typically when you remove cash value you will be paying a higher fee or decreasing your death benefit. When you get to the point of using your cash value, you will want to work with a financial advisor or insurance agent to make sure you fully understand the trade-offs.
Who Should Consider Life Insurance For Retirement Savings?
For the majority of people, your life insurance needs decrease as you approach retirement. You can look at any of the common methods to calculate your life insurance needs to see this is the case.
But using cash value as a supplement to your retirement income does make sense for some people. Typically the people who benefit from life insurance near and after retirement are:
- High net worth individuals: People who have maxed out their other retirement accounts and are looking for additional tax-deferred savings.
- Lifelong Dependents: If you have a lifelong dependent, like a child with a disability, you may want life coverage to provide protection for the child. Permanent insurance that serves as a dual purpose vehicle to provide that protection and offer supplemental income may fit your needs.
- Estate Planning: Similarly, when working with yoru financial advisor you may find that a permanent policy provides the option of retirement income and efficient passing of assets to your heirs.
The Final Word
There is a lot of confusion around life insurance. There are times when using life insurance to help supplement your retirement income makes sense. But this is typically reserved for people who have a high net worth and have maxed out there other retirement acounts.
For most people, a Roth IRA is a better initial use of your retirement savings. Despite the contribution limits, a Roth IRA has better tax treatment, lower fees, and better investment options.
Frequently Asked Questions (FAQs):
In general, a Roth IRA is a better vehicle for retirement savings than life insurance. However, there are 6 advantages life insurance has over Roth IRAs:
1) No Contribution Limits: Roth IRA has a $6,500 limit to annual contribution ($7,500 if over 50). Life insurance is limited only by becoming a modified endowment contract (MEC) and losing tax-advantages if you contribute too much. But you can avoid being a MEC by buying a sufficiently large enough policy.
2) No Income Limits: Roth IRAs have an income cut off of $153k for single filers and $228k for married filers. If your income is above the threshold you can’t directly contribute to a Roth. No income limit exists for life insurance
3) No Probate: Life insurance avoids probate by passing directly to the beneficiary upon death. Roth assets are part of the estate and go through probate.
4) No RMDs: Required minimum distributions (RMDs) apply for non-spouse heirs who inherit Roth funds. There is no RMDs for life insurance proceeds.
5) Volatility and Downside: There are many types of life insurance products that limit the volatility and downside from markets in the cash value account.
6) Death Benefit: Unlike a Roth IRA, you can pass on more to your beneficiaries than you contribute plus market performance. When you die, your beneficiaries will receive the death benefit amount.
Roth IRAs are generally a better method of retirement savings for most people. The benefits of a Roth IRA are:
1) Fees: Life insurance is very fee heavy with annual fees easily exceeding 3%.
2) Investment Options: Life insurance has limited investment options offered by the insurer. A Roth IRA allows you to invest in any investable security from ETFs to individual stocks.
3) Returns: Due to fees, product design, and investment options, your returns in a life insurance product tend to be lower than in a Roth IRA
4) Taxes: Roth IRAs are currently never taxable in both growth and withdrawals. Life insurance may be taxable depending on how much and how you draw down.
For most people, life insurance needs go down as they aproach retirement. However, there are 3 types of people who may benefit from using life insurance in retirement.
1) High net worth individuals: People who have maxed out their other retirement accounts and are looking for additional tax-deferred savings.
2) Lifelong Dependents: If you have a lifelong dependent, like a child with a disability, you may want life coverage to provide protection for the child. Permanent insurance that serves as a dual purpose vehicle to provide that protection and offer supplemental income may fit your needs.
3) Estate Planning: Similarly, when working with yoru financial advisor you may find that a permanent policy provides the option of retirement income and efficient passing of assets to your heirs.