Is a Life Insurance Retirement Plan Right for You?

A life insurance retirement plan (LIRP) is an insurance strategy where you pay more than the minimum premium to a permanent life insurance policy—whether it's variable, universal, whole life, or some other hybrid plan. The extra portion of the premium then goes into an account that builds cash value along with the death benefit, offering tax-deferred growth and a way to borrow money tax-free as long as you don't let your policy lapse.

LIRPs may be appropriate for ultra-high-net-worth individuals and families or high-income earners looking for "tax-bucket" diversification and are both maxing out their contributions to traditional retirement plans and contributing to after-tax brokerage accounts. But, for most, when it comes to putting extra dollars toward your premium with the intention of using life insurance funds for retirement income, you may want to consider alternatives like investing in your 401(k) or other tax-deferred retirement accounts instead.

For starters, the inherent cost of any permanent life insurance policy can become more expensive as you age, and the ongoing expense could exceed the cash value's potential growth. LIRPs also need a long-term commitment to avoid potential surrender charges and to allow the cash balance to grow beyond your contributions.

More importantly, a LIRP is highly dependent on having a knowledgeable insurance professional who can properly structure the insurance to meet your needs. It's not hard to find high-profile cases (or any case) where the strategy ends badly because the insurance policy "didn't do what it was supposed to do." And if you let your policy lapse because it no longer serves a purpose in your financial or estate plan, you'll likely owe taxes on any withdrawals in the year the policy ends.

Rather than relying on a life insurance retirement plan, here are three ideas to consider when balancing your insurance needs and retirement savings.

Term life insurance is a cost-effective way to replace your income if you die, and the death benefit can help minimize your loved ones' financial needs by covering expenses like your mortgage, your child's tuition, or other major bills. The cost for term life insurance coverage is typically less than premiums for the permanent life insurance policy in an LIRP, depending on your age, gender, health, family history, and other variables. You could then invest the money you save from buying term life insurance for your retirement needs.

For example, you could contribute enough to your 401(k) or 403(b) plan to earn the employer match, if available, or to an individual retirement account (IRA)—and even max out your contributions if you can afford it. If you're enrolled in a high-deductible health plan (HDHP) that offers a health savings account (HSA), you can also save money there to pay for current or future medical expenses, and after age 65, you can withdraw funds to use for any purpose—though you'll owe ordinary income tax on the amount.

Universal life insurance and whole life policies pay dividends and interest but with traditionally lower returns compared to an investment portfolio over the long term. And while variable life insurance products offer better growth opportunities than the other permanent life insurance options, they can have high expenses and limited investment options.

When it comes to taxes, you can't deduct permanent life insurance premiums, but generally you can withdraw from the cash value component tax-free, up to your total premium payments, and take tax-free loans on the gains. Take note, policy loans accumulate interest and could chip away at your insurance plan's performance, potentially putting the policy at risk of lapsing. If your policy lapses, you'll owe ordinary income tax on any gains, even those used for a loan. And if you die with an outstanding policy loan, the principal amount and interest will be deducted from the death benefit before any amounts are paid to your named policy beneficiaries.

IRAs, on the other hand, provide both a wider selection of investments and potentially higher returns, but they also have more complex tax rules regarding contributions and withdrawals. For example, contributions to a traditional IRA may be fully or partially tax-deductible based on your income and if you have a workplace retirement plan. However, once you turn 73 or 75—based on your birth year—you must begin taking annual required minimum distributions (RMDs), which are not only subject to ordinary income tax but the additional income could also push you into a higher federal tax bracket in retirement. That said, you'll be subject to a 10% penalty on any withdrawals you make before age 59½.

Although contributions to a Roth IRA aren't tax-deductible, you can withdraw them anytime tax-free and without penalty, regardless of your age. Also, Roths don't have RMDs, and after age 59½, you can withdraw any gains with no tax or penalty so long as you've held the account for at least five years. Be aware, Roths have income limits, so higher earners may not be eligible for direct contributions.

An annuity can offer the protection of insurance combined with investment features. There are two main types of annuities:

• Income, or immediate, annuities provide guaranteed income, based on the claims-paying ability of the insurance company, in retirement when you'll need to replace your salary. You can use your annuity payments to cover core expenses, such as utilities, mortgage or rent, property taxes, and other recurring obligations, and to supplement other predictable sources of income like Social Security or pensions.
• Deferred annuities offer tax-deferred growth on your premiums and potentially a death benefit for your beneficiaries. Later in life, you can annuitize your deferred annuity to begin receiving regular payouts to create an income stream. Tax-deferred annuities may also give you the option to add guaranteed lifetime income benefit riders, which allow you to get income for life without annuitizing. Although these riders increase the cost and complexity of annuities, they can be valuable for the right person. If you find you don't need the additional income in retirement, you can include your annuity in your estate plan to support your legacy and charitable giving.

Distributions from an annuity are taxable, but how much depends on whether it's qualified or nonqualified.

• Qualified annuities are purchased with money from accounts like an IRA or a 401(k), and distributions are typically fully taxed as ordinary income.
• Nonqualified annuities are purchased outside of qualified accounts with after-tax funds. Typically, only the earnings portion of your distribution is taxable while your contribution amounts, or cost basis, is considered a return of capital and is tax-free. However, there are different tax rules for nonqualified annuity distributions, so consult with your insurance provider and tax professional before you make a withdrawal or annuitize.

Also, be aware your distribution could trigger a 10% penalty, if you're under age 59½, and potential fees.

When it comes to retirement and investment strategies, you have a number of choices, and there's no one-size-fits-all answer. For most people, using term life insurance is the most cost-efficient way to protect your loved ones. But if you have extra income you want to save and have maxed out your available tax-deferred resources, talk with a financial advisor, estate planner, or tax professional to help you decide if any of these alternatives—or a combination thereof—might be right for you and your retirement goals based on your objectives and time horizon.