Just Say No to Universal Life Insurance as a Retirement Fund

Q: I’ve maxed out my savings with my Thrift Savings Plan and my Roth IRA. A financial adviser has suggested I invest in an equity-indexed universal life insurance plan because of the great tax benefits (I don’t have many other tax options that are favorable for me). I’ve got 35 years with the government and will retire in another five years or so. What do you think?

A: Unless you have a need for life insurance, and will have that need for the remainder of your life, I don’t think you have any business buying a universal life insurance policy as an investment.

To be fair, permanent life insurance products, such as universal or whole life, have some decent tax benefits. Any earnings will grow tax-deferred and any disbursements you take will be treated as withdrawing your deposits first, and any earnings second (this is the complete opposite of the horrible manner in which annuities are taxed). Furthermore, your “financial adviser” probably told you that you could “borrow” from your earnings, rather than withdrawing them, thereby eliminating any taxable income.

While the tax treatment of life insurance can be favorable, the cost of the life insurance often outweighs any tax benefits you may receive. So, you could pay into a policy for years, but much of your earnings will get eaten up by charges the insurance company hits you with to cover the costs.

There may be a place for universal life insurance for some people, but it is so often misused and sold to the wrong folks, so, as a rule of thumb, I say stay clear of it. For every one person I see who is truly maximizing the tax benefits, I see 10 other folks who could do a lot better by purchasing term insurance and investing the difference.

Obviously, I don’t know your full situation, but I doubt you have a need for life insurance until your dying day. Once you retire, you’ll have the option of protecting your spouse by taking a reduced pension that will continue to pay your partner after your death. This is a form of “life insurance” to be sure, but it’s a much better deal than trying to replicate the benefits by taking a single life pension option and buying life insurance to provide your spouse with income once you die.

So unless you have some other reason why you’ll need life insurance for the remainder of your life, forget the universal life insurance. Simply, the costs are greater than the tax savings.

There are, however, some other tax-favorable options to save more for retirement. For example, why not simply invest in a low-cost mutual fund that mirrors an equity index? These provide some great tax benefits, as well.

When you invest in an index fund, any price appreciation in that fund will grow tax-deferred. For example, if you purchase a fund at $10 per share, and it grows to $25 per share, you are not taxed on that growth until you sell the fund. All that appreciation has been tax-deferred.Once you are retired and want to take some income from the fund, you can sell just a portion of your holdings (as necessary), while realizing favorable capital gains treatment. Or, if you want to avoid taxes altogether, you can take a loan against your shares, similar to the life insurance being pitched to you, and avoid any income taxes.

And if you are concerned that investing in a stock index fund may be too risky, you could simply reduce your holdings in your Thrift Savings Plan (the government’s version of a 401(k)), so you can keep your portion of conservative investments “relative” to risky investments in check.

Finally, I question whether the person recommending the life insurance product is acting in your best interests. Unlike financial advisers, who are affiliated with registered investment advisors, insurance agents and stock brokers don’t have to make recommendations that are in your best interests. There is no legal requirement for them to do so.

Rather than working with a financial adviser who sells products (such as high-priced life insurance), I suggest you find an adviser who is affiliated with a registered investment adviser (RIA). This type of adviser not only has an ethical duty, but also a legal obligation to only make recommendations that are in your best interest.

Given that you are saving the maximum toward your 401(k), contributing to a Roth, and you will retire with a government pension, you are on your way to a very secure retirement. Congrats.