For the average person, saving for the future is a matter of taking advantage of the wide variety of available tools, such as 401(k)s or Roth IRAs through your job, working with a Certified Financial Advisor (CFA) or Certified Financial Planner (CFP), or personally managed retirement portfolios. Each of those tools has various positives and negatives; some are great for micro-managing assets, while others are better for different tax purposes.
When looking for tax deferred or tax free retirement income, most people first think Roth IRA, among other tools. However, some of those tools are not available to everyone, or present restrictions that do not fit the needs of a particular investor. Some tools, like the Roth IRA have maximum contribution restrictions, as well as maximum earned income amounts. For people who need to prepare for the future but can not use other tools (or who want an additional income stream in the future), an additional tool is a Life Insurance Retirement Plan.
Answers to 3 Common Questions About Life Insurance Retirement Plans (LIRP)
What is a Life Insurance Retirement Plan?
A Life Insurance Retirement Plan (LIRP) is an investment tool based off of an insurance policy. In the insurance industry, it is known as a variable universal life insurance policy, which the owner/investor then proceeds to overfund. A variable universal life insurance policy is a type of life insurance that allows more than the normal premium amount to be paid, and that amount is credited to the cash value of the policy.
When paying into this type of insurance policy, you pay your money to the insurance company, who puts it into an account. The amount in the account is the cash value of the policy. The cost of insurance, or the amount charged by the insurance company for the policy, is then deducted from that account each month. Any excess money that is in the account after that deduction can then be used for investing. Since life insurance is not taxed as income when it pays out, the value of the investments in the life insurance are also not taxed.
How Do I Use a LIRP?
By overfunding, or paying large additional amounts above the premium value, the owner/investor creates a pool of money by paying into the cash value portion of the policy each month. This excess money is then used to invest however the owner wishes, either through the insurance company or through personal choices. Most policies require that the contributor add to the account for a certain amount of time before any loans are taken, usually 10 or 15 years.
Then when supplemental income is needed, the owner can take a loan out against the cash value. Since there is a large investment made and it has had several years to grow, the owner can have a large amount of money to access, without needing to risk a house or other property as collateral.
The loan does not have to be paid back to the policy, and there are no personal negative repercussions for failing to repay the loan, such as damaged personal credit. Multiple loans may even be taken at the same time, so there is no need to repay the first loan to take a second.
What Should I Be Concerned About Before I Purchase?
There are some potential risks that you should be aware of before purchasing a life insurance retirement plan.
- Loss of Death Benefit. Loss of death benefit (the amount that is paid out to your survivors to aid in final expenses or as inheritance) can occur whenever the policy lapses or if the value of the loans that you take exceeds what is supposed to pay out and are not repaid before death. Since this type of policy is used as an investment and not typically for final expenses, it is highly recommended to have additional life insurance to cover those needs.
- Taxation on Lapsed Policies. Using the cash value as a loan source means that the source for paying the premiums (the cash value) will be lowered, and if lowered too much, then the policy could lapse. When that happens, under current tax laws, the value of the loans is counted as personal income is subject to taxation.
- Investment Risks. Because the policy premiums are paid from the cash value of the policy, if bad investments occur, then the cash value of the policy may not be enough to pay the premium. Bad investments usually occur when a person is managing their own investments in the policy instead of allowing the insurance company to manage them. That will cause the policy to lapse, and result in the loss of the death benefit and potential taxation on loans.
- Higher Insurance Costs. Because of the high reward on investment, the cost to purchase (cost of insurance) is typically higher for these policies. Since many individuals who seek these types of policies earn larger incomes, the insurance providers typically charge the higher premiums that they are capable of paying. Also, under current tax laws, as an investor ages, the cost of insurance can rise along with it, meaning that larger amounts are deducted from the cash value each month while the investor is using it as supplemental income, which can lead to policy lapse if not carefully watched.
Retirement planning is difficult for everyone. Planning for an uncertain future, predicting your needs, and ensuring that all final preparations are made for when the time invariably comes can stress anyone out, but working with a financial planner can help you to be as best prepared as you can be. Using a Life Insurance Retirement Plan can be an excellent safety net for supplemental income needs, just be sure to examine all the costs and benefits with an advisor before purchasing one.