Don't Overlook Advantages of Making Insurance Part of Your Retirement Plan

Life insurance can offer income and saving options for the long term.

(Image credit: blackred)

Many people don’t fully understand the value and benefits life insurance can offer as part of a retirement plan.

Most view life insurance primarily as a way to protect a family from the loss of income should a breadwinner die during his or her working years. If that’s an individual’s main purpose in purchasing a policy, it’s a good one. But that income-replacement function doesn’t have to — and, in my opinion, probably shouldn’t — come to an end in retirement.

When one spouse passes away during retirement, the surviving spouse (usually the wife) often struggles financially. While some living expenses might be lower when there’s just one person in a household, the reduction in costs rarely offsets the drop in income. At a minimum, one of the two Social Security checks the couple was receiving will go away. Sometimes, a pension payment also is lost or is cut to 50% or 75% of the original amount. Life insurance can be used to ensure there is enough money to compensate for that missing income, allowing the surviving spouse to maintain his or her standard of living throughout retirement.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

Tax-free treatment

But what I like best about life insurance are the tax advantages.

Congress has included several provisions in the tax code that give life insurance income tax and transfer tax benefits:

Death benefits

Death benefits usually are paid income-tax-free to beneficiaries and may also be free from estate taxes, as long as the estate stays under the taxable limit (currently $11.4 million for single individuals and $22.8 million for couples, although state limits can be much lower). Of course, those estate tax exclusions are also true of any assets you pass down to your heirs, not just life insurance.

Accelerated death benefit

Benefits paid out before the insured’s death because of chronic or terminal illness also are tax-free. This is known as an accelerated death benefit (ADB) and is a relatively new option. As a result, elderly individuals who have had their policies for many years may find no mention of the ADB option in their policy. Interested individuals should ask their life insurance provider directly if this option is available. If one’s current insurance plan does not already provide this coverage, it can sometimes be added as a rider. This simply means the extra benefit can be added to the insurance policy, sometimes at a cost.

The major advantage to receiving an ADB is that it allows the policyholder to have a portion of their death benefit in advance of their death. There are no major drawbacks to this option; its biggest limitation is that policyholders are required to be terminally ill, or in some cases, chronically ill. There are other options for policyholders who require care, some for those who are terminally or chronically ill, and some for those who are not.

Cash value

Cash values can grow within a permanent life insurance policy without being subject to income tax. And cash values exceeding the policy owner’s tax basis can be borrowed income-tax-free as long as the policy stays in force. There are drawbacks to that, of course. If you were to die before paying back your policy loan, the loan balance plus interest accrued is taken out of the death benefit given to your beneficiaries. This could be a problem if your beneficiaries need the entire amount of the intended benefit. When the loan sits unpaid, the interest that accrues is added to the principal balance of the loan.

If the loan balance increases above the amount of the cash value, your policy could lapse and risk termination by the insurance company. In the event of a policy lapsing or being surrendered, the loan balance plus interest is considered taxable income by the IRS, and the taxes owed could be a fairly large amount depending on the initial loan and interest accrued.

Of course, as with any investment, there are critics. As we’ve outlined above, there are pitfalls involved with borrowing from an insurance policy, and you absolutely should work with a professional you can trust to be certain your policy is properly structured for the purposes you have in mind.

But often the critics’ opinions are based on misinformation or are intended to steer people away from insurance and into other investment options instead. Many advisers who don’t offer life insurance say it’s too expensive — and, yes, life insurance does come with fees. So do 401(k)s, traditional IRAs and Roth IRAs. Fees are an unavoidable aspect of any retirement savings plan.

Competitive fees

Naturally, you don’t want to pay more in fees than necessary, but when life insurance is structured properly, the fees are extremely competitive. Fees include sales charges, administrative expenses and surrender charges, plus the underlying cost of the insurance, which while you’re young is low, but as you age it grows. According to Brightscope, the average total expenses for a large-company 401(k) plan are about 1% of the entire account balance per year.

Mutual funds have expense ratios as high as 1.5% to 2%. With the advisory fee added, many mutual fund investments could cost you 2.5% to 3% annually, and that doesn’t include additional transaction fees that are generated when the money manager buys and sells within the fund.

Generally speaking, the fees in properly structured life insurance contracts are higher in the earlier years and lower in the later years, and over the life of the program these fees can average as little as 1.5%. The key lies in the proper structuring of the life insurance contract from the outset.

To maximize cash accumulation and minimize expense, the contract must contain as little life insurance as possible while being funded at the highest level allowed by IRS guidelines. This maximum funding scenario ensures that the level of expense, as a percentage of the overall contributions remains as low as possible. Whether you contribute the minimum required to keep the policy in force or the maximum allowed under IRS guidelines, your expenses won’t change. To achieve fees as low as 1.5% over time, the death benefit must be reduced as low as possible while at the same time maximizing contributions. So, the question one must ask is: Do the benefits of owning a life insurance contract outweigh the inherent costs to the investment?

In addition, when you compare apples to apples, life insurance fees are mostly front-loaded — which means you’re paying more in fees when the account balance is low and less in fees when the account balance is larger, after it has grown. Life insurance has mortality fees that support the life insurance benefit. And there are additional fees that support the expenses of establishing, underwriting and managing your account. But for these fees you receive some incredible benefits to include a death benefit, tax-free growth and withdrawals and of course the power of indexing to grow your funds over time.

Most assets worth owning — and that have the potential to create wealth — come with some acquisition or transaction costs, including real estate, art or gold.

Explore your options

Just because you aren’t working anymore doesn’t mean you don’t still need the protections and benefits life insurance can offer. If you’ve overlooked the potential that the right policy could have as part of your retirement plan, start by doing some research. Treat it as you would any other investment: Determine your specific needs, find out what you can about the companies that offer insurance, and get referrals for a specialist who can walk you through the pros and cons of what different policies have to offer.

Kim Franke-Folstad contributed to this article.


This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Richard Pucciarelli, Investment Adviser Representative
President and founder, Carolina Retirement Resources Inc

Dr. Richard Pucciarelli is the president and founder of Carolina Retirement Resources Inc. He has over 15 years experience serving retirees and pre-retirees in planning for and protecting their financial futures. Pucciarelli is an Investment Adviser Representative and a licensed insurance professional. He hosts the "Financial Symphony" show on WBT Radio 1110 AM every Saturday morning at 11 a.m.