Life insurance isn’t a replacement for more traditional retirement plans, but there are some strategic advantages. Supplementing a 401(k) with cash value life insurance can enhance your retirement savings with tax-free distributions, no stock market risk, and more flexibility.
We’ll be comparing specifically indexed universal life policies (the type of insurance typically used for wealth building) with qualified plans (401k, IRA, 403B)
Use the links below to jump to any section of the article.
- What is a qualified plan?
- Popular wealth-building strategies
- What is indexed universal life insurance?
- Pros & cons of qualified retirement plans
- Pros & cons of indexed universal life policies
- In reality, what works best?
- How Abrams Insurance Solutions can help
Qualified plans are fantastic for taking advantage of employer contributions. They’re also easiest to find information about because they’re the most common forms of retirement savings strategies.
Indexed universal life is a lesser-known way to build a tax-free retirement income stream.
What is a Qualified Plan?
Qualified plans (aka qualified retirement plans) let you put your income toward retirement while getting some simultaneous tax advantages.
Qualified plans fall under two categories: defined-benefit plan and defined-contribution plan.
Defined-benefit plans typically refer to pensions. Your employer tells you what your benefit amount (the amount your pension is worth) will be. Factors can include various benchmarks like years worked and income level.
Most working people today have defined-contribution plans. Rather than telling you what your employer will provide as a pension, you have an account you can contribute to – a 401k, IRA, and the like. Some employers match contributions up to a point.
Since the government expects you to do your own financial research and make the decisions, it’s on you to contribute and grow your retirement funds.
On qualified plans, Uncle Sam can either tax you now or tax you later. Financial planners argue over what strategy is better, but like most things, it depends on the person – their financial education, discipline, and circumstances.
IRA stands for Individual Retirement Account. You would set up this qualified retirement plan on your own. Virtually every institution offers traditional IRA accounts. However, there are a few sub-categories of IRA that may provide even more advantages.
You contribute to a traditional IRA with pre-tax or post-tax dollars. The account grows. Then you pay taxes when you take out your money in retirement. This strategy works best for people who believe they’ll be in a lower tax bracket in retirement than they are now.
A Roth IRA does the opposite. You contribute with post-tax dollars. The money grows tax-free, then your retirement distributions are also tax-free. The limiting factor on this is you can’t be in a high tax bracket to contribute. The 2022 qualifying income limits are $129,000 for a single head of household and $204,000 for married filing jointly.
As of 2022, the maximum annual contributions for an IRA are $6,000, or $7,000 if you’re over 50.
401(k) is the most common type of employer-sponsored qualified retirement plan.
You contribute with pre-tax dollars, and it grows tax-deferred. Then you pay taxes on the distributions you take from the account. You can start taking distributions at 59.5 years old (without penalty) but have to begin taking distributions (called required minimum distributions or RMDs) at age 72.
You can annually contribute much higher amounts in a 401(k) than an IRA. Whereas IRA limit you to $6k – $7k a year (depending on age), 401(k) limits contributions at $20,500 as of 2022. If you’re over 50, the max 401(k) contribution increases to $27,000.
Employers tend to fall into one of three categories:
- 100% match to a limit
- 50% match to a limit
- No match
A 403(b) and 401(k) do the same things in most regards. You contribute with pre-tax dollars. The investments grow, then you pay taxes on your distributions.
They even have the same annual contribution limits.
Only public sector employees have access to a 403(b) qualified retirement plan. Think of positions like government employees, teachers, firefighters, etc.
The other difference lies in the extra catch up contributions available for a 403(b). You can contribute an additional $3,000 per year (up to a lifetime max of $15,000) if you’ve worked for the same employer with a 403(b) for at least 15 years. This particular catch up contribution does not impose an age limit.
Popular Wealth Building Strategies
In addition to qualified retirement plans, we have as many options as we can imagine for building wealth. Investors seem to be thinking up more every day.
People build wealth through all sorts of methods:
- Stock trading
- Real estate
- Peer-to-peer lending
- Certificates of deposit
- Currency exchange
- Side hustle businesses
- Passive income strategies – think AirBnB or book royalties
These have varying rates of return, as well as various risk levels.
Most qualified plans allow you to make use of many of these techniques. It’s up to your interest in self-managing these. Although a great financial planner can take much of the work out of strategy.
One option that is catching on more and more is building wealth with life insurance. Life insurance, and especially indexed universal life or IUL, is a great strategy for creating tax-free distributions with no stock market risk.
What is Indexed Universal Life Insurance?
Indexed universal life insurance focuses on building cash value as fast as possible. It’s the life insurance component that gives it tax advantages as a retirement income stream.
The cash value in an IUL links to a stock marketing index – usually the S&P 500. Because it is not directly invested in an index, the insurer sets up the policy so you cannot lose money. They call this the growth floor. It also has a growth ceiling, typically set between 12 and 14%. There are also many uncapped options.
An experienced agent will set up the IUL with the largest premiums for the smallest benefit. This sounds strange, but it’s to your advantage. The less you spend on the death benefit, the faster you build the cash value.
How It Accumulates Cash Value
As you pay premiums, part of that goes toward the cash value of the policy.
Each year, the insurer will credit your cash value interest based on how the index performed. If the index grew 8% that year, your cash value increases by 8%.
With the ceiling and floor, other options might look like:
- Index grows 18% – your cash value increases by 14% (the ceiling)
- Index drops 10% – your cash value earns 0% interest (the floor)
After a lousy market year, the growth starts from where it ended. Even if the index takes a year or two to regain what it lost, your cash value still grows every year the index makes gains. Think of it like a staircase, where a bad year is a landing before the next flight of stairs.
For regular IUL policies, it can take 5 -10 years before the cash value is worth accessing. Naturally, this varies widely depending on the year, insurer, and how much you’re paying in premiums.
One big advantage of the IUL over a 401(k) or IRA is that you can access money in the IUL before you are 59.5 years old without paying a penalty.
How People Use This as Retirement Income
After a decade or so of cash value growth, you can have a good size nest egg built up.
There are no requirements for borrowing against your cash value. It’s not like qualified plans where you’re required to take distributions. You use your cash value as you see fit.
What most people do is take a set amount from it each year. This amount is calculated with the assistance of their agent or financial planner. It’s set to ensure that the amount you draw out, plus accumulated interest over your retirement, doesn’t exceed the total cash value.
That way, no matter how long you live, you can’t outlive your money. Plus, there will still be a life insurance benefit for your heirs.
Remember that because the cash value keeps growing based on the total amount (not total less any loans), most people can get to the point where the cash value growth exceeds their loans plus accumulated interest.
Pros & Cons of Qualified Retirement Plans
QRPs have a bunch of advantages and are a wise first step to setting yourself up for a comfortable retirement.
Modern QRPs often come with company matches. People call this free money – although you’re still working for it. It gives you the advantage of putting away a little more each month.
Many of the more traditional retirement vehicles can have fantastic returns. There are no caps, and the sky is the limit. This pairs well with more options for risk tolerance. You can also adjust your risk tolerance as you get closer to retirement.
Some of the drawbacks would be if you don’t work at a company has a 401(k) match. Switching companies (which most people do every 3 years) leaves you with a bunch of small 401(k)’s that you have to either consolidate or deal with.
If you need help rolling over an old 401(k) to an IRA or another option, please contact us.
Preferred Features of Different Savings Options
The chart below shows features in the first column that you want to either have or avoid. The second column shows that ideal wealth building vehicle which, unfortunately, doesn’t exist. So the next best thing is to check as many boxes as possible.
The various wealth building options show across the top row, starting with an IRA – 401(k). You can see that this strategy has only two green boxes. The rest of the option have one, two, or three green boxes.
Indexed universal life (in the last column) has the most green boxes, representing the most characteristics you want in your plan.
Pros & Cons of Indexed Universal Life Insurance
Indexed universal life insurance also comes with its advantages and drawbacks.
Instead of buying a life insurance policy (if you need it) in addition to your retirement, the life insurance is built-in.
Withdrawals are all tax-free. The IRS considers life insurance loans to be loans and not taxable income.
You have a growth floor. You can’t lose money like you can if your 401(k) is heavily invested in the stock market.
There is also the potential of fully-funding the policy over 10 or so years, so you never have to worry about paying premiums as you get older.
Not everyone can take advantage of an IUL. It’s best for people making $60,000 or more a year.
There is no free money – like the match from an employer.
Growth ceilings can limit what you get on a fantastic year. Although, in most cases, you come out ahead having a floor. You’re better off giving up a little of the upside to have the downside protection.
How to Increase Your Retirement Income 60% to 100%
For high-income people, there is another option. You can add leverage to an IUL. In this case, a bank pays for 75% of your premiums, letting you start with a much higher cash value. The higher early cash value lets your IUL grow even faster. The extra boost provides 60% to 100% more retirement income.
You can learn more about adding leverage to an IUL here. The minimum income needed to qualify for this program is $100,000.
Conclusion – In Reality, What’s the Best Option?
The best option needs to fit your circumstances – income, family, retirement goals, etc.
What works for most people is to take advantage of traditional qualified retirement plans. Especially if there is an employer match available, it’s a reliable option.
Building on top of QRPs is where the IUL comes in. It provides a second retirement income stream that can’t lose money on a bad year. For example, in 2008 or even 2020, when people got hit by the economic crises, traditional retirement methods suffered, and people watched their account values plummet.
An IUL creates a hedge against that sort of thing. But it’s not a good standalone retirement plan. If you can’t pay premiums and the policy lapses, you’re left with nothing.
Blending the two provides the biggest advantage by spreading the risk over a couple of retirement income streams.
Since it’s difficult to really understand the impact of a retirement plan without looking at numbers, here’s a sample of what different retirement accounts would look like for a 47-year-old man as he contributes and after he retires.
This compares saving the same amount of money into an IUL (in green) to a taxable account (red) to a tax-deferred account (blue) and a tax-free account (purple).
You can see the cash value potential of each type of retirement vehicle based on their tax status. Here is what happens with the cash after our test case retires and starts taking distributions. You will notice that the Cash Flow for the tax-deferred account in higher. That’s the amount our example person would have to draw from the account to pay the taxes to retain $65k as income.
These charts show how running out of money in retirement may unfold.
Taking the same amount of income out in each strategy, the taxable account runs out at age 76 and the tax-degerred and tax-free accounts run out at age 80. The IUL runs through age 95 and will continue beyond if you have a longer life. Plus, the IUL also offers a sizable death benefit for your loved ones.
The best solution is to cover all of your bases by participating in your qualified retirement plans up to the match. Then look at funding tax-free options, such as an IUL.
How Abrams Insurance Solutions Can Help
We’re focused on helping our clients solidify their financial foundation. Then start building reliable wealth structures on top of it. Whether that’s putting together a customized IUL for someone or recommending they hold off for a few years, we pride ourselves on providing personalized advice to each client, reflecting their needs and goals.
Give us a call today with any questions at 858-703-6178. We’re happy to help, and there is never any obligation to move forward.