Tax Free Retirement for Life Insurance

Jim is 54 years old and has been a client for many years. He works in sales and makes decent money. He is now more interested in retirement. He is looking to generate income to supplement Social Security. He doesn’t want to be more invested in the stock market. He believes he is at too much risk with his 401(k), and wants to do something else.

He is also worried about the impact taxes may have on his retirement. Jim contributed only pretax to his 401k, and all future withdrawals will become taxable. This will affect his retirement tax rate. Jim wants to leave his daughters an inheritance.

Plan now!

We discussed many options, including a Bond Ladder, rental property, dividend-paying stock and other ideas. Jim should also start saving in his Roth401(k). In retirement, Roth 401(k), withdrawals are exempt from tax Jim liked the Roth idea, but he wasn’t interested in the other suggestions.

Then I mentioned to Jim that some clients use full life insurance to generate retirement income and leave an estate. Jim was confused. Jim was unsure at first. He doesn’t need traditional life insurance. His mortgage is low and his children are not in college. He also has a term $500K life insurance policy through his job. I suggested that we look at the numbers.

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Retirement planning: Whole-life insurance

Jim is 54 years old and in good health. A $250K whole-life policy from a highly rated mutual organization costs $13,805 annually for 12 years. The policy is paid up after 12 years. There are no additional premiums. This is in line with his 65-year-old retirement target. Jim intends to withdraw from his 401k between 65 and 70 in order to have retirement income. To begin Social Security, he would prefer to wait until he reaches 70. To supplement his income, he can withdraw from his whole-life insurance policy starting at 70. He can withdraw at any time, but waiting will help the policy grow. Jim is expected to have a cash value of $218,309 at age 70 if he pays his premium for 12 consecutive years. The death benefit at age 70 is estimated to be $380 509.

Jim can withdraw $18,319 per annum for 15 years at age 70. This is one option. This is a flexible period. Jim can begin income sooner or later. Jim wanted to increase his income in the active retirement years, which he did from 70-84. He can keep taking income up to 84 if he so chooses. He can withdraw less annually and his death benefit is lower if he takes income longer.

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Initial withdrawals are a return on his base (his premiums). Soon after, the withdrawals become loans from the policy. These loans and withdrawals are not taxable. Jim doesn’t have to repay the cumulative loan. Jim can choose to not repay the cumulative loan. The unpaid balance of the loan is subtracted from his death benefit and the remainder goes to his daughters.

The total benefit

Jim would pay $165,660 total premiums for 12 years, or $13,805 per year. He does however take out $274,788 as retirement income. This is the $18,319 per annum for 15 years. He also has an income-tax-free death benefit for his family of $91,784. Jim drew money 15 years ago from the policy, reducing his death benefit to $91,784.

Jim pays $165,660 in premiums for a total benefits of $366572. This is Jim’s in-life retirement income at $274,788 and a death benefit at $91,784 should Jim pass. Jim’s return over time on his investment is measured by how much he pays in premiums and how much he gets. This is called the Internal Rate of Return (IRR) which is tax-free at 4.26%. The Internal Rate of Return (IRR) is a measure that measures an investment’s return over time, taking into account cash outflow and inflow. The policy is in effect for Jim’s entire life. It does not end at age 84. This is only an illustration. Jim would need to earn 6% before taxes if he is in the combined 30 federal and state tax brackets. This will allow him to reach the 4.26% IRR after taxes – not something to be ashamed of. Jim was told by me to consider his entire life in the fixed income allocation.

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Caveats

Performance is driven by dividends. Although whole life insurance companies can credit an annual dividend to their policy, they don’t have to. This can be reinvested in the policy. Jim may withdraw less if the insurance company credits a lower dividend for a longer period of time. Jim could also earn more if dividends are good. This is something that we will need to keep an eye on. We may, for example, take less income in low dividend years to not stress the policy.

Jim must also pay the premium over 12 years. He doesn’t need to pay the premium from his salary. He can also use his savings or idle cash. The premium must be paid in any case. Some premiums may be forfeited if you surrender the policy before the due date. Jim was confident that he could afford 12 years of premiums. He had saved all his life for this purpose.

You are also relying upon the solvency and health of the insurance company. A highly rated mutual insurer company that has a track record of paying dividends is recommended.

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The whole picture is possible when you combine everything.

Jim was able to see the many benefits of whole life insurance as a source of retirement income. Whole life insurance provides diversification. When the stock, bond and real estate markets crashed in 2008, I didn’t notice any changes to my cash value in my whole-life policy.

Jim can use his whole life to help him manage his tax liabilities in the future. Jim can withdraw less from his 401k over the years, which reduces his overall taxable income. Because Social Security benefits are taxable, a portion of his taxable income is lower.

Jim also appreciated the long-term life insurance that he could provide for his daughters. He is aware that even if his 401(k) was paid off in retirement, he would still be able to leave the entire life insurance death benefit to his children.

Jim can also add a long term care rider to his whole life policy. Jim can use the long-term rider to get his death benefit to help pay for qualified long term care expenses. This could be skilled nursing, home health care, or assisted living. The annual cost to the rider is typically only a few hundred more.

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Whole life insurance is a great option for retirement planning if you have the right circumstances. Whole life insurance provides diversification over traditional bond and stock portfolios. Whole life permits tax-free loans and withdrawals. The family receives a long-term benefit from whole life. The whole life can be used to pay for long-term care costs in the future.