Using Life Insurance to Diversify Your Retirement Plan


Today, more individuals are using life insurance for purposes other than its basic offer – to secure a death benefit should something happen to you. Depending on your income and goals, life insurance can play a useful role in tax diversification and, ultimately, a diversified retirement plan. This type of diversification is similar to that in investment portfolios.

These differing intentions for a life insurance product fall into two categories:

  1. Protection: The product is used strictly as life insurance, with the aim of getting the most amount of insurance for the least amount of premium.
  2. Efficiency: The product is used as cash value life insurance, which the insured over-funds. The value over insurance cost goes back to the insured.

Cash value life insurance is the road less explored in terms of retirement planning. However, a recent change enacted in the Consolidated Appropriations Act, 2021, makes the option more attractive. The below questions explore using life insurance to diversify your retirement plan, how the Consolidated Appropriations Act affects the value of such a strategy, and key considerations for retirement planning as a business owner.

Why Diversify My Retirement Plan in the First Place?

Having multiple, varied options in your retirement “portfolio” helps ensure a steadier course toward the retirement you’re planning for. It’s wise to have traditional tax-deferred plans and investments, but those returns depend on the market. The returns aren’t fixed or guaranteed, and deferred taxes will eventually come due, as well as capital gains taxes. In addition, distributions from traditional retirement plans will be taxed based upon current income tax rates, which change over time.

A life insurance plan is taxed differently. This money is possibly non-taxable, similar to the way Roth IRAs are tax-free. Such a plan can be an anchor for an otherwise variable retirement strategy.

What Does a Diversified Retirement Plan Include?

A diversified retirement plan is commonly composed of these three buckets:

  1. A tax-deferred, defined benefit plan, such as a 401(k) or traditional IRA.
  2. After-tax investments into accounts that will have taxable capital gains when investments are sold.
  3. A tax-free plan, such as a Roth IRA or life insurance policy.

A life insurance policy can be an excellent alternative to a Roth IRA for high-income individuals because:

  • Roth IRAs have maximums, currently around $6,000 per person.
  • Qualifying life insurance policies have no maximums on savings per year.
  • Roth IRAs have income limits excluding or limiting those with over $198,000 joint income.
  • Qualifying life insurance policies do not have income limits.

Additionally, life insurance plans have no early termination policies or penalties for distributions before the age of 59. And those distributions can come out tax-free if your plan is designed appropriately. Retirement plans typically have strict rules and penalties for such activity.

When planning for life insurance, multiple factors are at play depending on your circumstances. You might need to plan for family, estate, business and charitable components. It helps to have a professional review your insurance options so you get the right coverage.

Is the Life Insurance Cost Worth the Tax Savings?

Though life insurance is an expensive fee vehicle, the opportunity for the cost to be worth the tax savings is greater today than it has been for decades. That’s because of the Consolidated Appropriations Act, 2021.

The Consolidated Appropriations Act, 2021 changed the tax code rule under IRC Section 7702 such that the key interest rates for permanent and long-term life insurance policies went from 4% to 2%. This is a recalculation based on today’s historic low interest rates and the high percentage of long-term insurance holders. The law went into effect on January 1, 2021.

Before this change, these rates hadn’t been revisited and adjusted for over 35 years.

This adjustment also keeps the life insurance plan from being categorized as a modified endowment contract. With modified endowment contracts, the IRS can tax the plan like an annuity if you put too much money in it.

Under the new interest rate, you can put more money in your life insurance than before without violating IRS modified endowment contract rules, and thus, without IRS penalty.

As the death benefit is based on the interest rate, and the insurance cost is based on the death benefit, this adjustment creates a higher savings and tax efficient opportunity. Consumers get lower-cost permanent life insurance policies that look and feel like Roth IRAs, and, if designed appropriately, the cash in the contract can grow tax deferred and be taken out tax-free.

Here's an example: Say a 35-year-old individual with high income got a life insurance policy before the tax law change. The death benefit would have been around $1.7 million based on the old interest rate. If that same individual instead gets a policy after the change, their death benefit will go down to $900,000 based on the new interest rate. Thus, the insurance cost will be lower.

Which Life Insurance Policies Can Be Used in Retirement Planning?

To use life insurance as a tax diversification strategy, it must be a permanent cash value life insurance policy, such as whole life and universal life.

  • Whole Life: Relies on insurance company performance and receiving a dividend. That is how cash value builds. It does not rely on market returns.
  • Universal Life: Fixed, indexed and variable are all universal life insurance policies. They rely on market returns.

Life Insurance as a Toolbox

Consider this hypothetical: a 50-year-old executive with high income is planning for retirement who also needs life insurance. The Executive wants to plan for long-term care and is also interested in deferring tax and growth.

This third bucket, using life insurance as an alternative to a Roth IRA, could be a useful tool due to its flexibility (for instance, a purpose for the life insurance does not have to be decided on yet).

In the meantime, money can potentially be taken out tax free and the death benefit can be used for certain care expenses. It can also be used to assist with estate planning.  

Insurance, financial planning, retirement and business transitions have inherent complexities. If you’re looking to make the best moves, our team of specialists have lengthy, proven backgrounds in these areas.

Financial Advisor offers Investment Advisory Services through Eide Bailly Advisors LLC, a Registered Investment Advisor. Securities offered through United Planners Financial Services, Member of FINRA and SIPC. Eide Bailly Financial Services, LLC is the holding company for Eide Bailly Advisors, LLC. and Eide Bailly Agency, LLC. Insurance products are offered or issued via Eide Bailly Agency, LLC. Eide Bailly Financial Services and its subsidiaries are not affiliated with United Planners. Not all products and services are available in all states.

The views expressed are those of the advisor and may not reflect the views of United Planners Financial Services. Material discussed is meant to provide general information and it is not to be construed as specific to investment, tax or legal advice. Individual needs vary and require consideration of your unique objectives and financial situation.

Diversification is a strategy to manage risk, but no investment strategy can guarantee profits or protection against losses in declining markets.

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