Most people use employer-provided retirement plans and IRAs to hold their retirement savings. But when you have a substantial cash value inside a life insurance policy, you can tap those funds as part of a life insurance retirement plan (LIRP).
In this article, we review how a LIRP works, and we explore some of the pros and cons of a retirement strategy that relies on life insurance. We’ll also evaluate other ways to fund your retirement in a tax-aware manner.
Definition and Examples of a Life Insurance Retirement Plan (LIRP)
Permanent life insurance policies, such as whole life and universal life insurance, have a cash value account. A life insurance retirement plan uses this cash value account to hold retirement assets. The strategy requires building up a cash value that you can draw from to supplement your retirement income. Eventually, you might be able to borrow from your policy or take withdrawals from the cash value to pay for things in retirement.
Using life insurance for income might make sense for someone who already has a life insurance policy with a significant cash value and who no longer needs insurance protection (or won’t when they plan to retire). The strategy also might appeal to those who prefer to minimize market risk, although other alternatives may be a better fit.
- Acronym: LIRP
Life insurance companies stress that a life insurance policy should only serve as a supplement to other retirement savings, and using your policy for retirement could negatively impact your coverage.
How Does a Life Insurance Retirement Plan (LIRP) Work?
Permanent life insurance policies include a cash value that can grow over time. When you pay premiums into a policy, you typically pay more than is required to provide life insurance protection and maintain your policy. The excess money builds the cash value. Any growth in your cash value is tax-deferred, and over many years, you might accumulate a significant amount.
With a LIRP, your cash value becomes the source of your supplemental income. You can access cash value through loans against your policy or through withdrawals. Both of those income sources may be tax-free, but there are limitations and potential consequences of tapping your cash value:
- Withdrawals are tax-free until you take out more than you paid into your policy; after that, withdrawals may be taxable.
- Loans result in interest charges, and any unpaid loan balance when you die leads to a smaller death benefit for your beneficiaries.
If you take withdrawals, be mindful of surrender charges. Depending on how long you’ve had your policy, the insurance company might assess penalty fees that reduce the proceeds if you’re still in the surrender period; typically, these are the early years of your policy, but can last up to 20 years.
When building your cash value with permanent life insurance, you need to be aware of tax rules. For example, if you contribute more than IRS guidelines allow, the policy could become a modified endowment contract (MEC). That outcome would undermine a strategy that relies on life insurance as a potential source for tax-free retirement funds, as your withdrawals are more likely to be taxable.
On a loan, unlike a withdrawal, interest is charged on the amount “loaned,” but that same amount may still earn interest as part of the cash value. Cynthia Meyer, CFP® of Real Life Planning, says that life insurance loans do not affect your debt-to-income ratio (which affects your ability to borrow for home loans and other loans). Plus, you don’t need to qualify for a life insurance loan. If the money is available in your cash value, you can get it—regardless of your credit score.
Meyer stresses that life insurance should not be used primarily as a retirement vehicle. However, if you have a policy with a substantial cash value, you can consider that money a bonus to supplement your existing retirement plan.
Despite the pitfalls, life insurance policies make it relatively easy to access funds. When compared to retirement accounts like IRAs and 401(k) plans, loans and withdrawals can provide easy access to tax-free funds before age 59 ½.
As an idealized example, assume you have an old permanent life insurance policy you and your loved ones no longer need. If your current tax situation makes it unacceptable to cash out the policy and reinvest the proceeds (or if you like the idea of keeping the death benefit in place during retirement), you can take supplemental income from the policy.
To supplement your retirement income with life insurance, you need a substantial amount of cash value in a permanent insurance policy.
Several varieties of policies exist, including whole life insurance, universal life, and variable life policies. Whole life insurance typically offers the most certainty when it comes to cash value growth, but the earnings in universal and variable policies potentially could outpace the growth inside of whole life policies.
If you decide to draw funds from a policy, you can do so using loans and/or withdrawals. For example, if investments in your IRA lose value in a market crash, it could make sense to take income from a life insurance policy instead (to avoid selling investments in your IRA at steep losses).
However, you need to ensure you keep enough cash value in your life insurance policy to avoid a policy lapse. As Meyer says, when you borrow or withdraw too much, your policy may lapse, and you may face exactly what you’re trying to avoid: taxes.
Using your cash value can result in tax consequences if your policy lapses or if you withdraw more than you paid into the policy. While loans aren’t taxable, unpaid loans reduce the amount your beneficiaries receive, and they can cause your policy to lapse, which could result in taxation.
Pros and Cons of a LIRP
- Death benefit for beneficiaries if you keep the policy in force
- Potential for guaranteed values when using whole life insurance
- Ability to eliminate market losses with some products
- Potential to take tax-free income early
- Can’t use all of your money unless you surrender the policy
- Potential tax consequences after an unexpected lapse
- Standard long-term investments might offer more long-term growth
- Paying fees for life insurance protection might not make sense
- Interest costs on loans
If you keep your policy in force, meaning you don’t surrender your policy for the cash value or let it lapse, life insurance can provide a death benefit to help your loved ones after your death. If you can’t stomach the ups and downs of the markets, a whole life policy has a predictable growth rate and a guaranteed cash value to draw from in the future.
However, you can’t actually use all of the money you accumulate in a life insurance policy. You need to keep enough inside the policy to pay for insurance costs and other internal charges. That may lead you to question whether or not it’s worth paying those fees in the first place.
When compared to other retirement tools like an IRA, life insurance might not be the best option. Borrowing against your policy results in interest charges, and that’s an expense you wouldn’t pay when taking withdrawals from retirement accounts. Plus, withdrawals in excess of your basis in the life insurance contract are taxable. If you have the time and risk tolerance to invest for growth, the fees and crediting formulas in an insurance policy might not produce as much growth as investments in an IRA.
You can get tax-free income from Roth IRAs once you turn 59 ½ and on withdrawals up to the amount of your contributions before age 59 ½.
Alternatives to LIRPs
- IRA: Individual retirement accounts (IRAs) provide tax-deferred growth, and you can spend 100% of the money in your account without paying interest on loans or worrying about a policy lapse. If you choose a Roth IRA and satisfy IRS requirements, your withdrawals can be tax-free in retirement.
- Workplace retirement plans: 401(k), 403(b), and other plans allow you to save significantly more than an IRA. With Roth 401(k) and Roth 403(b) options, you may be able to accumulate meaningful assets for tax-free income later.
- HSA: Health Savings Accounts (HSAs) may allow for pre-tax contributions, tax-deferred growth, and tax-free withdrawals when used for qualified health care expenses. However, you only qualify for contributions by using certain high-deductible health plans.
- Taxable accounts: Standard individual or joint investment accounts allow for complete control over withdrawals and investments. While these accounts lack tax benefits, you can invest with tax-aware strategies.
- Annuities: Annuities provide tax deferral that might be helpful after you’ve maxed out other retirement programs. Annuities also offer insurance company guarantees, such as lifetime income.
- Term insurance and a retirement or taxable account: If you don’t have a permanent need for a death benefit, term insurance might be able to protect your loved ones for a set number of years while you “invest the difference” in an investment account, such as an IRA or brokerage account. (“Investing the difference” refers to the difference in cost for a permanent versus term life insurance policy.) However, it’s critical to determine if your need is temporary or permanent. Discuss your goals with several life insurance agents before making a decision.
Most retirees pay surprisingly little in taxes—the average federal and state income tax rate is 6% for U.S. retirees. The wealthiest families in the U.S. might benefit from life insurance more than the average household, but it’s critical to look at the big picture, and taxes are just one piece of the puzzle.
Can You Fund an Early Retirement With Life Insurance?
There are several ways to fund an early retirement, and life insurance is just one of them.
With permanent life insurance, you can take loans or withdrawals at any age, and there are no taxes due unless your withdrawals exceed your basis, which is, generally, the amount you’ve paid into the policy. However, other strategies, such as a Roth IRA or taxable brokerage account, allow you to withdraw funds before age 59 ½, and they don’t require you to pay interest to access your money or keep funds in reserve to avoid a policy lapse.
For example, with Roth IRAs, you can withdraw your regular contributions at any time with no taxes or penalties. If you have money in pre-tax retirement accounts, you can establish a series of substantially equal periodic payments, also known as 72(t) payments, to avoid early withdrawal penalties. Alternatively, if your employer offers a 457(b) plan, you might be able to take withdrawals with no early withdrawal penalty.
Your taxable holdings generally are available at any time, and if you take long-term capital gains, the tax implications might be acceptable. Explore your options with a CPA because tax laws periodically change, and mistakes can be expensive.