Jim is 54 and a longtime client. He is in sales, earning decent money. Lately, he is thinking more about retirement. He wants to create a stream of income to supplement Social Security. However, he does not want to invest more in the stock market. He feels he has enough at risk in his 401(k) and wants something different.
He is also concerned about how taxes will affect his retirement. Jim made only pretax contributions to his 401(k), and all his future withdrawals will be taxable. This will impact his future retirement tax rate. Jim also wants to leave an inheritance for his two girls.
Time to plan
We reviewed several ideas, including a bond ladder, rental real estate, dividend-paying stocks and other suggestions. I also recommended Jim start to save in his Roth 401(k). Roth 401(k) withdrawals are tax-free in retirement. Jim liked the Roth idea; however, his interest wasn’t piqued with the other suggestions.
I then mentioned that some clients use whole life insurance to produce retirement income and leave an inheritance. Jim was unsure. At first glance he doesn’t have a traditional life insurance need. His mortgage is small, and the kids are out of college. Plus, he has a $500K term life insurance policy through work. I suggested we review the numbers.
Whole life insurance for retirement planning
For Jim, who is 54 and in decent health, a $250K whole life policy from a highly rated mutual company has an annual cost of $13,805 for 12 years. After 12 years the policy is guaranteed paid-up – no more premiums. This matches up nicely to his target retirement age of 65. From 65-70 Jim plans on withdrawing from his 401(k) to provide retirement income. He would like to wait till age 70 to begin Social Security. Starting at age 70 he can use the withdrawals from his whole life insurance policy to supplement his income need. (He can take withdrawals at any age, but waiting helps the policy grow. Assuming Jim pays his premium for 12 years, the projected cash value at age 70 is $218,309. The death benefit at 70 is projected to be $380,509.)
One option we discuss is that at age 70 Jim withdraws $18,319 per year for 15 years. This is a flexible time frame. Jim can start income earlier or later. However, Jim wanted to maximize income during his active retirement years from age 70-84. If he wants to, he can continue to take income beyond 84. Taking income for longer lowers the death benefit and lowers the annual amount he can withdraw.
At first the withdrawals are a return of his basis (his premiums). Shortly thereafter the withdrawals switch to loans from the policy. These withdrawals and loans are not taxable. Jim does not need to repay the cumulative loan. If he chooses not to repay the loan, the unpaid loan balance is subtracted from the death benefit at his passing and the rest goes to his daughters.
The total benefit
In this scenario, Jim pays $165,660 in total insurance premiums – 12 years at $13,805. However, he takes out $274,788 in retirement income (the $18,319 per year for 15 years, rounded up). Plus, he still has an income-tax free death benefit for his family, which at age 84 is $91,784. The death benefit is reduced to $91,784 because Jim withdrew money from the policy for 15 years.
In other words, Jim spends $165,660 in premiums to create a total benefit of $366,572 (Jim’s in-life retirement income of $274,788 plus a death benefit of $91,784 should he pass). Jim’s return on his investment over time –measured by the premiums he spends versus the total benefit he receives – is a 4.26% tax-free Internal Rate of Return (IRR). (IRR is a measure of an investment’s return over time considering cash outflow and inflow.) Note the policy continues for Jim’s whole life, it does not stop at age 84, this is just for illustrative purposes. If Jim is in the combined 30% federal and state tax bracket, he would have to earn 6% before taxes to achieve the 4.26% after-tax IRR – nothing to sneeze at. I told Jim to look at whole life as part of his fixed income allocation.
Dividends drive performance. Whole life insurance carriers can – though they do not have to – credit an annual dividend, which can be reinvested into the policy. If the insurance company credits a low dividend for a longer time, Jim’s withdrawals may be less. On the flip side, Jim’s income could be higher if dividends do well. It is something we will have to monitor along the way. For example, in a low dividend year, we may take less income so as not to stress the policy.
Jim must also pay the premium for 12 years. It doesn’t have to come from his salary; he can use his idle cash or other savings. Either way the premium does need to get paid. Surrendering the policy early may forfeit some of the premiums paid. Jim felt comfortable he could afford to pay for 12 years. He was using the whole life as part of his annual savings.
Also, you are relying on the insurance company’s health and solvency. For this reason, I recommend using a highly rated mutual insurance company with a long track record of paying dividends.
Putting it all together – the whole picture
As I explained to Jim, there are several benefits of using whole life insurance for retirement income. Whole life provides diversification. In 2008, when the stock, bond, and real estate market tanked, I didn’t see any change to the cash value in my own whole life policy.
Whole life can help Jim manage his future tax liability. In the years Jim takes withdrawals from his whole life policy, he can take less from his 401(k), reducing his overall taxable income. Lower taxable income may lower the taxes due on his Social Security benefit since a part of Social Security is taxable based on your income.
Even more, Jim appreciated having long-term life insurance for his two girls. He knows that even if he spent down his 401(k) in retirement, he would still have the whole life insurance death benefit to leave to the kids.
Finally, Jim could choose to add a long-term care rider to the whole life policy. The long-term care rider allows Jim to access the death benefit while he is alive to pay for qualified long-term care expenses. This can be home health care, assisted living or skilled nursing care. The additional cost for the rider is usually only a few hundred dollars extra per year.
For the right situation, whole life insurance can help with retirement planning. Whole life provides diversification to a traditional stock and bond portfolio. Whole life allows for tax-free withdrawals and loans. Whole life provides a long-term death benefit for the family. Whole life can help pay for future long-term care expenses.
If you are interested in learning more, please feel free to send me an email, or I suggest reaching out to an experienced independent insurance agent who can help you evaluate whether whole life is right for you.
Investment advisory and financial planning services are offered through Summit Financial LLC, an SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666. This material is for your information and guidance and is not intended as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting with their independent tax or legal advisers. Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is not a guarantee of future results. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Links to third-party websites are provided for your convenience and informational purposes only. Summit is not responsible for the information contained on third-party websites. The Summit financial planning design team admitted attorneys and/or CPAs, who act exclusively in a non-representative capacity with respect to Summit’s clients. Neither they nor Summit provide tax or legal advice to clients. Any tax statements contained herein were not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state or local taxes.
Michael Aloi is a CERTIFIED FINANCIAL PLANNER™ Practitioner and Accredited Wealth Management Advisor℠ with Summit Financial, LLC. With 21 years of experience, Michael specializes in working with executives, professionals and retirees. Since he joined Summit Financial, LLC, Michael has built a process that emphasizes the integration of various facets of financial planning. Supported by a team of in-house estate and income tax specialists, Michael offers his clients coordinated solutions to scattered problems.
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