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Tax Benefits of Life Insurance: Compare with Other Retirement and Investment Options

If you’re planning on retiring sometime, either in the near future or somewhere further down the road, you should have a strategy. A key element in your retirement strategy is deciding where are the best places to invest your money. Which investment accounts give you the best ROI (return on investment)? Which have the best tax advantages? What are the fees associated with each type of investment? Here, we’ll examine common retirement accounts and the tax advantages and disadvantages of each. 

 401(K)Traditional IRARoth IRAInvestment accounts like Vanguard, Wealthfront, or Charles SchwabPermanent Life Insurance Policy
EligibilityOffered by companiesAnyone who earns incomeDepending on income. Not available if income is less than $139,000 a year or $206,000 for couplesAnyoneAnyone with insurability evidence (can pass a medical exam)
Premiums—tax deductible?Yes-Yes, if no qualified employer like 401(K) available.
-No, if there is 401(K) or similar employer programs
No No No
Limit investment/premium amountYes, $19,500 max a year, plus another $6 for those 50 or olderYes ($6,000 for both traditional and Roth IRA combined$6,000 for both traditional and Roth IRA combined, plus an additional $1,000 if you’re over 50NoNo (policy can be designed to accommodate any max premiums)
Investment growth – tax deferredYesYesYes YesYes
Taxable when withdrawing?YesYesNo YesNo 
Penalty when withdrawing? Yes. 10% penalty on the withdrawal amount before 59.5 years oldYes. 10% penalty on the withdrawal amount before 59.5 years oldNoNoNo
Taxable when the beneficiary withdraws?YesYesNoYesNo

Ed Slott – a renowned tax expert – on tax benefits of IUL policies

Compare quotes of 30+ IUL products

Compare Tax Benefits Between 401K Accounts and Permanent Life Insurance Policies

A 401(K) is a retirement savings plan that your employer offers you as part of your benefits package. After most employers decided that pensions were far too expensive, they replaced them with 401(K)’s as a way for employees to save for retirement. If you work for a non-profit, they’ll offer you a 403 (b) instead. They’re much the same thing, although a 403 (b) may not offer as many investment choices.  

If your employer offers one, a 401 (K) or 403 (b) should be your first choice when it comes to investment strategies for retirement. Often times, companies will match your contributions, giving you a 50% ROI right away. Sometimes they’ll limit the amount they’ll match, for example, they might match 100% of your contributions up to a certain percentage of your salary. If you leave your job, you can roll the funds over into an IRA. If your employer goes bankrupt, your 401(K) is protected. 

The advantage of 401(K) and 403 (b) plans, even if your employer doesn’t contribute, is that it’s easy. The money is deducted from your paycheck and invested before you ever see it. Another great benefit is that the amount you put in your 401K is deductible for your income tax.

Both allow you to deposit money before taxes are taken out. This means that you can save a bigger chunk of income, but you’ll pay taxes on that money when you go to withdraw it. And if you withdraw from your 401k before you reach 59 1/2 years old, you will be required to pay penalty fee of 10% on the amount you withdraw.

There are also limits to how much money you can contribute to a 401(K): for 2020, the IRS says you can contribute up to $19,500 a year, or $26,000 if you’re over 50.

This is where life insurance, especially indexed universal policy or variable universal policy, has advantages over 401K or 403(b):

  • Universal life policies do not have limit on the amount you want to put in every year. The policy can be designed to allow you to invest in as much as you can afford as long as it doesn’t become a modified endowment contract (MEC). This is where a licensed advisor or life insurance agent can advise you on.
  • It doesn’t have penalty on whenever you want to withdraw either as long as the cash value account of the policy can afford it.
  • And most importantly, when you withdraw from indexed or variable universal life insurance policies (IUL or VUL) to supplement your retirement income or for any emergency expenses, it is completely income tax free. This is the biggest advantage of an IUL or VUL policy over other retirement savings options. It is also the biggest benefit in the tax code, according to Ed Slott, a tax expert. Here is what he explains further about this amazing benefit.

If your employer doesn’t offer 401(K) options, consider an IRA.

Ed Slott – a renowned tax expert – on tax benefits of IUL policies

Compare quotes of 30+ IUL products

Compare Tax Benefits Between Traditional IRA Accounts and Permanent Life Insurance Policies

An IRA is a straightforward way to save for retirement. You can contribute pre-tax income to the account, and the money the investments earn is also tax-deferred. Once you withdraw the money, though, you’ll have to pay taxes on the money at your ordinary income tax rate. If you withdraw before you turn 59 and ½, you’ll pay a 10% penalty, plus income taxes at your regular rate, although there are some exceptions. 

There are limits to how much you can contribute to an IRA, however. For 2020, it’s $6,000 ($7,000 if your over 50). It should be noted that this is the total you can contribute to both a traditional IRA and a Roth IRA. 

Permanent life insurance policies also have tax advantages over traditional IRA account the same way as they do over 401K as compared above.

Compare Tax Benefits Between Roth IRA Accounts and Permanent Life Insurance Policies

Maximum contribution for 2020 for both IRA’s and Roth IRA’s combined is $6,000, plus another $1,000 if you are over 50.

You must also be under the income limit to be able to contribute to a Roth—in 2020, your modified adjusted gross income must be lower than $124,000 if your single, head of household, or married filing separately and less than $196,000 if you’re a married couple filing jointly or a qualifying widow (er). 

If you are self-employed, there is something called a SEP IRA, which allows you to contribute up to $55,000 or 25% of your income, whichever is less. 

The amount you invest in a Roth IRA account is after-tax money, ie. after you already pay income tax.

The advantage of a Roth is that the money grows tax-free (remember, the money is invested) and it will be tax-free when you withdraw it. And you can withdraw whenever you want, as long as your Roth IRA account is more than 5 years old. This is similar to the benefits of permanent life insurance policies.

However, the advantages of permanent life insurance policy over a Roth IRA account are the following:

  • You can invest in as much as you want in a permanent life insurance policy such as an indexed universal or variable universal policy.
  • You can invest in an indexed universal or a variable universal life insurance policy for retirement savings regardless of your income. Learn more about how to invest in an indexed universal policy for retirement savings

Ed Slott – a renowned tax expert – on tax benefits of IUL policies

Compare quotes of 30+ IUL products

Compare Tax Benefits Between Traditional Investment Account Compared and Permanent Life Policies

Vanguard, Wealthfront, or Charles Schwab are popular investment management companies. They all offer “robo-advisors”—essentially wealth management software. They can advise you where to invest your money based on your goals, your risk tolerance, and how much money you have to invest. They also allow you to work with financial planners and advisors to help you manage your assets for your goals.

They all have tools to help you optimize tax efficiencies in your investment. However, compared with permanent life insurance policies, they offer few tax advantages. You have to invest with your after-tax dollars and you have to pay standard income tax when you withdraw.

>>MORE: How to Use Life Insurance in Retirement Planning? A Case Study to Compare Life Insurance Policy with Vanguard Brokerage Account

Summary of Tax Benefits of Permanent Life Insurance Policies

Life insurance can be part of a comprehensive retirement strategy, with the main advantage being the tax-deferred cash accumulation, plus the tax-free when withdrawing. A Life Insurance Retirement plan (LIRP) is a permanent life insurance policy which is designed to maximize cash value of the policy. You can then withdraw and borrow against this money, tax free, after you retire.

The other advantages of universal life insurance policies used for retirement savings are the flexibilities that they offer:

  • You can invest as much or as little as you can afford
  • Regardless your income, you can always invest in a permanent life insurance for retirement savings. It is usually indexed or variable universal life policy.
  • You can increase and decrease or skip premiums at any time
  • The cash value of the policy will earn high interest rate like an investment account by investing in high-performing indexes such as S&P 500 or NASDAQ. You will never lose money since there is floor control, usually 0 or 1%.
  • Finally, you never have to pay income tax when you withdraw or borrow from your permanent life policy.

Ed Slott – a renowned tax expert – on tax benefits of IUL policies

Compare quotes of 30+ IUL products

When does Life Insurance Make Sense?

If you have a need for life insurance, a permanent life insurance policy can be a good strategy to help fund your retirement. Especially if you’ve maxed out other retirement funds, the tax advantages of life insurance can make sense. 

If you don’t have a need for life insurance and are not a high-income client, you may do better to first invest your money in 401(K)’s, IRA’s or Roth IRA’s first, and then consider a permanent life insurance policy. Life insurance can also protect your beneficiaries from taxes when they inherit the death benefit, which they will appreciate. 

For high-net worth people, this can be a good strategy because when you borrow against your life insurance policy, it is not included your taxable income. This should lower your taxable income and help these customers qualify for a lower-tax bracket. 

While whole life is not usually an effective vehicle for retirement due to the high costs, a universal life, indexed universal life or variable life policy are often a good way to supplement retirement. See our case studies for a more thorough look at how these types of policies can be an effective retirement strategy, especially when you consider the tax benefits. 

Conclusion

Planning an effective retirement strategy takes a lot of work and management. Knowing where to invest your money might make the difference between a comfortable retirement and struggling every month. Do your homework and consider consulting with a financial advisor.

Ed Slott – a renowned tax expert – on tax benefits of IUL policies

Compare quotes of 30+ IUL products

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