The cash value of permanent life insurance policies can be used to hold retirement assets in a plan known as a LIRP (Life Income Retirement Plan).
In this piece, we will discuss how a LIRP operates as well as the benefits and drawbacks of using life insurance as part of a retirement strategy. We will also look into other ways to save for retirement that will help you save less on taxes.
An Explanation of What a Life Insurance Retirement Plan Is, Along with Some Examples (LIRP)
A Life Income Retirement Plan (LIRP) is a plan for retirement that makes use of the cash value of permanent life insurance policies, such as whole life and universal life insurance, in order to hold retirement assets. The tactic demands that you accumulate a cash value that you can later use as a source of supplementary income throughout your retirement years. At some point in the future, you might be able to withdraw money from the cash value of your policy or take out loans against it to pay for things during your retirement.
- Acronym: LIRP
Using life insurance as a source of income may make sense for a person who already possesses a life insurance policy that has accumulated a sizeable cash value and who does not require insurance protection at this time (or who anticipates that they will not require it when they retire). Those who want to reduce their exposure to market risk may also be interested in the strategy, but there may be other options that are a better fit for them.
Many providers of life insurance emphasize that a life insurance policy should only be used as a supplement to other types of retirement savings and that utilizing your policy for retirement could have a negative influence on your coverage.
Life Insurance Retirement Plan (LIRP): What Is It and How Does It Operate?
Permanent life insurance policies typically come with a cash value component that has the potential to increase over time. When you pay premiums into a policy, the amount that you pay is often greater than that which is required to offer protection from life insurance and to keep your policy in force. The value of the cash is increased by the surplus funds. Any increase in your cash value is subject to tax deferral, and if you wait a number of years, you could end up with a sizeable sum of money.
If you have a LIRP, the source of your supplementary income will be the cash value of the policy. You have two options for accessing the cash value of your policy: either take out a loan against it or withdraw the money. Although neither of these kinds of income may be subject to taxes, there are several restrictions and potential repercussions that come with accessing your cash value:
- Once you have taken out more money from your insurance than you have contributed to it, all withdrawals you make beyond that point may be subject to taxation.
- When you take out a loan, you will accrue interest charges, and if you pass away with a loan balance that is not paid off, your beneficiaries will receive a lower death benefit.
If you make withdrawals from your account, you need to be aware of the surrender charges. If you’re still in the surrender period, the insurance company may apply penalty costs that lower the proceeds if you’re still in that time; normally, these are the early years of your policy, but they can extend up to 20 years. These fees vary depending on how long you’ve had your policy.
You must be informed of the applicable tax laws in order to successfully build up the cash value of your permanent life insurance policy. If you donate more money to the policy than the guidelines set out by the IRS allow, for instance, it is possible that the policy will transition into a modified endowment contract (MEC). Because of the increased likelihood that your withdrawals will be subject to taxation, a strategy that relies on life insurance as a potential source for tax-free retirement money would be rendered ineffective in the event that this scenario occurs.
In the case of a loan as opposed to a withdrawal, interest is charged on the amount considered to be “loaned,” yet the same amount may still earn interest as a component of the cash value. Your debt-to-income ratio will not change as a result of taking out a loan to pay for life insurance, according to Cynthia Meyer, CFP® of Real Life Planning (which affects your ability to borrow for home loans and other loans). In addition, you won’t have to worry about getting approved for a life insurance loan. No matter what your credit score is, you will be able to collect the money from your cash value if it is available.
Meyer emphasizes that life insurance should not be used as a retirement vehicle as the primary purpose of the policy. On the other hand, if you have a policy that has a significant cash value, you can think of that money as an added bonus to augment the retirement plan that you already have.
In spite of the potential risks, life insurance policies make it quite simple to retrieve the money in the policy. When compared to retirement accounts such as IRAs and 401(k) plans, loans and withdrawals can allow easier access to funds that are exempt from taxation prior to the age of 59 and 12 years.
Consider the following hypothetical scenario: you and your loved ones no longer require the permanent life insurance coverage provided by an old policy that you own. You have the option to receive supplemental income from the policy if your current tax status makes it unfeasible to cash out the policy and reinvest the funds (or if you enjoy the notion of keeping the death benefit in place during retirement), both of which are valid reasons.
To use life insurance as an extra source of income during retirement, you will need a permanent policy with a good amount of cash value.
There are many different kinds of plans available, such as whole life insurance, universal life insurance, and variable life policies. When it comes to cash value growth, whole life insurance plans are known to provide the highest degree of predictability. Nevertheless, the earnings from universal and variable policies have the potential to outperform the growth that is included in whole life policies.
If you make the decision to take money out of an insurance policy, you have the option of taking out loans or just taking the money outright. For example, if the investments in your IRA lose money because of a market crisis, you may want to take money out of your life insurance policy instead of your IRA (so you don’t have to sell investments in your IRA at steep losses).
However, in order to protect your life insurance policy from expiring, you need to make sure that you keep a sufficient amount of cash value in it. According to Meyer, if you take out too much money from your policy or borrow too much money, your policy could expire, and you would then be subject to the same thing. You are attempting to avoid taxes.
If your policy expires or you withdraw more money from the cash value account than you put into the policy, you may face tax repercussions as a result of using your cash value. Unpaid loans not only result in a reduction in the amount of money your beneficiaries are entitled to receive, but they also put your policy at risk of lapsing, which could lead to further taxation. A Look at the Benefits and Drawbacks of a LIRP
- If you keep your insurance active, your beneficiaries will get a death benefit.
- The possibility of obtaining certain benefits when utilizing full life insurance
- The potential to reverse market losses experienced by certain items
- Disadvantages of being able to access tax-free money sooner;
- You are restricted from using all of your money unless you give up the policy.
- Potential tax ramifications after an unexpected lapse
- Investing in traditional long-term assets may result in more growth over the long term.
- It’s possible that shelling out money for life insurance protection isn’t worth it.
- The cost of interest accrued on loans
If you keep your policy in force, which means you don’t surrender it for the cash value or let it lapse, your life insurance policy may be able to pay a death benefit to your loved ones after your passing. This may ease the financial burden that your death places on them. A whole-life policy offers a predictable growth rate and a guaranteed cash value that can be withdrawn at some point in the future. People who can’t handle the ups and downs of the financial markets should get this kind of policy.
On the other hand, you won’t be able to access the full amount of cash that accumulates in a life insurance policy. You have to set aside enough money in the policy to cover the cost of the insurance and any other fees that may come up. Because of this, you may begin to wonder if it is truly worthwhile for you to pay such fees in the first place.
When weighed against other vehicles for saving for retirement, such as an IRA, life insurance might not be the most advantageous choice. When you take money out of your retirement account rather than borrowing against your policy, you won’t have to pay interest because retirement accounts are considered a tax-deferred investment vehicle. In addition, any withdrawals that are made that are greater than your basis in the life insurance policy will be subject to taxation. If you have the time and are willing to take on some level of risk in order to invest for growth, you should know that the costs and crediting formulas associated with an insurance policy may not yield as much growth as the investments you make in an IRA.
After reaching age 59, you are eligible to receive tax-free income from Roth IRAs, and you can withdraw up to the amount you contributed to the account before turning 59.
Alternatives to LIRPs: Individual retirement accounts (IRAs) Individual retirement accounts (IRAs) provide tax-deferred growth, and you can spend one hundred percent of the money in your account without having to pay interest on loans or worry about a policy lapse. Another advantage of IRAs is that they are portable. If you choose a Roth IRA and meet the rules set by the IRS, you may not have to pay taxes when you take money out of the account when you retire.
Workplace retirement plans, such as 401(k), 403(b), and other plans, give you the opportunity to save a lot more money than an individual retirement account (IRA). You could be able to build up significant assets for tax-free income in the future if you take advantage of the Roth 401(k) and Roth 403(b) alternatives.
HSA: Health Savings Accounts (HSAs) may allow for contributions to be made before taxes, growth to occur tax-deferred, and withdrawals to be made tax-free if the funds are used for approved medical expenses. If you don’t have one of the qualifying high-deductible health plans, you won’t be able to get a contribution.
Accounts that are subject to taxation: Whether you choose to open an individual or joint investment account, you will have complete control over your withdrawals and investments. You can invest with tax-aware tactics, despite the fact that these accounts do not offer any tax benefits.
Annuities offer tax deferral, which may be advantageous when you have reached the maximum contribution limit for other retirement schemes. In addition, annuities come with promises from the insurance provider, such as a steady income for life.
Insurance with a fixed term and either retirement or taxable account: Term insurance is one option for protecting your loved ones for a predetermined amount of time if you do not have an ongoing requirement for a death benefit. This allows you to “invest the difference” in an investment account, such as an individual retirement account (IRA) or a brokerage account. “Investing the difference” refers to the financial difference between purchasing a term life insurance policy and a permanent life insurance policy. Nevertheless, it is essential to ascertain whether your requirement is temporary or permanent. Have a conversation about your objectives with a number of different life insurance brokers before selecting a choice.
Surprisingly little is paid in taxes by the majority of pensioners; the average combined federal and state income tax rate for retirees in the United States is 6%.
It’s important to look at the entire picture, and taxes are just one piece of the jigsaw; life insurance may assist the wealthiest families in the United States more than it does the typical household, but it’s also important to remember that taxes are just one element of the problem.
Is It Possible to Retire Earlier Than Expected With Life Insurance?
Buying life insurance is one of the many ways to provide financial support for early retirement.
If you have permanent life insurance, you can take withdrawals or loans at any age, and you won’t owe any taxes until the amount of your withdrawals is greater than your basis. Your basis is the amount of money that you have put into the policy up to that point. However, some strategies, like a Roth Individual Retirement Account (IRA) or a taxable brokerage account, permit you to take assets before the age of 59, and they do not require you to pay interest to access your money or hold funds in reserve to prevent a lapse in coverage.
For instance, if you have a Roth IRA, you are free to withdraw any of your regular contributions at any time without being subject to any kind of taxation or penalty. If you have money in pre-tax retirement funds, one way to avoid early withdrawal penalties is to set up a series of substantially equal periodic payments, often known as 72 (t) payments. You can do this to prevent taxation on the money. 6. Alternately, if your company participates in a 457 (b) plan, you might be able to access your funds without incurring any penalties for withdrawing them early.
Holdings that are subject to taxation can normally be sold at any time, and if you do so in order to realize long-term capital gains, the associated tax implications may be manageable. Talk to a certified public accountant (CPA) about your options because tax rules change often and making a mistake can be very expensive.