In this article, we’ll consider what role, if any, whole life insurance might play in your retirement income plan. Although the death benefit is still in view, we’ll focus on leveraging the cash-value (investment) component to help fund your retirement income stream.
More and more retirement planning professionals emphasize that creative solutions will be needed to fund a long retirement. Those with small to moderate amounts of savings will need to be especially flexible in how they set up their retirement income plans.
A school of thought known as the “safety-first approach” is being promoted by a number of leading retirement planners, economists, and academics. Unlike the traditional “Social Security plus pension (if you have one) plus savings” approach to funding retirement, they see a greater role for various insurance products to help retirees manage retirement risk. These risks include market risk, sequence risk, and longevity risk.
This isn’t entirely new. Insurance companies have long promoted the benefits of permanent insurance and annuities as retirement savings and income tools. However, the financial advisor community and consumers in general haven’t widely embraced them. That is beginning to change; planners and advisors increasingly use a mix of risk-based assets (investments) and insurance-based products (life insurance and annuities) in the retirement income plans they build for clients. They are viewed as especially useful in the “guaranteed income floor with upside” retirement income strategy.
Many insurance products have historically had a “bad rap,” mainly because of their complexity and cost, but that has improved. That said, cost and complexity remain concerns, so if you choose this route, consider adding them to a mix of Social Security and savings, and make sure you understand what you are buying and what it will cost.
Whether we are talking about life insurance or annuities, the basic business operating principle for insurance companies is the same: They use “risk pooling” across a broad base of customers to enable them to pay average benefits to customers with average longevity. Those who live a long time pay for the benefits of those who don’t, but everyone participates in the “pool” as long as they’re alive.
I am not suggesting this is a bad thing. It’s essential to understand how these products work so you can make informed decisions about whether to buy them.
Tax implications of whole life
When it comes to retirement planning, taxes matter. Whether we’re talking about tax deferral in retirement savings accounts or tax-free withdrawals from Roth accounts in retirement, taxes are always part of the retirement equation.
Retirement accounts like 401(k)s and IRAs offer tax advantages. The most significant is that contributions may reduce your taxable income in the year you make them, and they grow tax-free during the accumulation phase, adding to the compounding effect. Roth accounts offer tax-free withdrawals in retirement, but “traditional” (meaning contributions were pre-tax) 401(k) and IRA accounts do not.
Whole life insurance policies fall into this same category—they also offer several tax benefits.
The main tax advantage of whole life insurance is that beneficiaries receive the death benefit tax-free. (The same is true with term life, as long as you pass away during the covered term.) The policy loans that we discussed in the first article are tax-free as well, so long as you manage them correctly. (You have to pay interest, but you don’t have to pay taxes on it.) As the first article points out, it’s not that different from withdrawing from your bank account, but it is different from selling investment assets and paying capital gains tax.
Also, like retirement savings accounts, the cash value of your whole life policy grows tax-free, i.e., no annual capital gains or dividend taxes on growth. And if managed properly, most withdrawals (including earnings) are tax-free as well. (Withdrawals from traditional retirement accounts are taxed as income when withdrawn in retirement. Roth accounts are the exception—they are tax-free.)
If you cancel your insurance account and withdraw 100% of the funds, you may have to pay taxes on all the “tax-free” gains you ever received. Also, unlike retirement savings accounts, the cash accumulation in a whole life policy doesn’t add to the death benefit and cannot be passed to heirs; the insurance company keeps it.
Policy withdrawals as income
Whole life insurance can provide several ways to generate income flexibility in retirement.
First, the cash value of a whole life policy can provide income in retirement. Because it is guaranteed to grow (at a minimal rate) and is protected from market-related losses, you can use it to supplement retirement spending instead of selling investment assets during down market conditions. You would access those funds by making periodic tax-free withdrawals from the cash account. But you have to be careful here. If you withdraw too much, you may reduce your death benefit or eliminate it.
Second, if you want income you won’t run out of in retirement, an immediate income annuity is another option. In many cases, you can convert the cash value of a whole life policy to a lifetime income annuity. Should you “cash-out” the policy, you will lose the death benefit, but you will have a guaranteed lifetime income stream.
Third, you could use your whole life policy to ensure the “second to die” has enough money to live on for the rest of their life—but that depends on the covered person being the “first to die.” To ensure that either spouse is taken care of, both would need to be insured. A joint survivor income annuity may be a better option.
Finally, instead of withdrawing from the cash-value account, those who want to keep the policy’s death benefit in place could borrow from it instead. (We looked at policy loans in the first article.)
When considering retirement income options with whole life, keep this in mind: You are bound by the contractual terms of the policy you purchased.
When they start withdrawals in retirement, many retirees will first stop paying premiums. That’s not a problem if you have a “paid-up” policy. Then, they withdraw money (tax-free) from the policy and spend the proceeds as income. Still, not necessarily a problem. The problem arises when you withdraw more from the cash-value account than you’ve paid in premiums—your cash basis. In that case, the IRS will tax your gains as ordinary income. The death benefit will also be reduced by the total amount you withdraw.
Instead of withdrawals, you may decide to take out a loan. Again, not a problem as long as you meet the policy’s terms. In this case, the insurance company lends you the money and holds your policy as collateral. Any unpaid interest is added to the loan. If you stop making premium payments and your loan exceeds the policy’s cash value, your policy could lapse. If you can’t afford higher premiums to keep the policy in effect, or you can’t repay the loan, the policy will be terminated. At that point, all tax-free withdrawals become taxable—not a good situation.
Whole life dividends as income
Over time, as your cash value grows, the insurance company (at least those that are “mutual” companies) declares a dividend. The dividend amount depends on your cash value and the insurance company’s performance. (They invest in the same stocks and bonds that we do.) Dividends aren’t guaranteed (they aren’t with company stocks either), but most companies pay them regularly.
For example, if the company declares a 5% dividend, and you have $10,000 cash value, then $500 is credited to your cash value. The dividend percentage applies only to the cash value and is unrelated to your actual return on that cash value. Most whole life policies have a negative return for at least the first 5 to 10 years.
In some respects, whole life dividends could be considered a “return of premium”; the insurance company took in more than it needed and is returning some portion of it to you. Therefore, dividends aren’t taxed because they aren’t income. (This is in contrast to distributions from “traditional” retirement savings accounts that are taxed.)
You can choose what happens to the dividends. You can take them as cash income (before or in retirement), use them to pay premiums, or to purchase “paid-up additions,” in other words, more insurance. Most choose the third option, which facilitates tax-protected growth of the policy value and a slowly increasing death benefit. But they later switch to “take them as income” when they need income in retirement.
Income annuities and life insurance
I have written extensively about annuities. Income annuities could fit into many retirees’ retirement plans to help manage market and longevity risk. They pay “mortality credits” to recipients who live beyond their average life expectancy, since those who die early subsidize payments to those who live longer.
Whole life can also be used alongside annuities as part of a retirement plan.
First, some may decide to convert a whole life policy to an annuity to provide additional income in retirement. The accumulated cash value of the policy is converted to a lifetime annuity. If the cash value exceeds the amount you have paid in premiums, the difference is taxable income upon conversion.
A second option involves purchasing whole life insurance (with its permanent death benefit) and then annuitizing an amount of savings equal to the value of the death benefit. The rest of their savings would go into investments. This method uses the death benefit to replace the annuitized assets, which would then pass to heirs (if that was the person’s intent).
This approach may appeal to people who are reluctant to annuitize assets only to pass away early (making it a “losing bet” on longevity). That is where the permanent death benefit comes into play—they can think of it as a kind of “refund” of the annuitized assets paid out after their passing.
However, positioning it so they can annuitize some assets while also preserving a death benefit for heirs may be more appealing.
Final thoughts
First, I see nothing in purchasing a whole life insurance policy, regardless of your reason, that violates any biblical principles. However, as with all financial products and solutions, we must take care not to let them become our ultimate source of hope and security—God is (1 Timothy 6:17).
If you currently own a whole life policy, the premiums are manageable, and you have generally been happy with the growth of its cash value, I would suggest keeping it and using it to supplement your income in retirement or leave a legacy to your heirs, if that is your desire. If you want to leverage the cash value for other purposes, that’s fine too; just make sure you can repay it if you want to retain the full death benefit.
If I needed a loan and the cash was in an insurance policy I already had, I’d probably use it. That said, I’m not sure I would recommend buying a new whole life policy mainly for that purpose.
Most people need life insurance. They would typically buy a policy for that purpose, not as a long-term investment. If you are convinced the investment component is worth the higher premiums and you’re intentionally looking for a combo product, that’s fine—just be aware you may be leaving money on the table from a pure investment-performance standpoint.
Combing insurance and investments complicates the simple life insurance equation. It can also obscure unnecessary expenses. So separate the insurance from the investment so you understand what it costs and can compare it to alternatives (such as term). Then figure out what the investment part is costing and what it might earn, and compare it to investing in an IRA earning 6% after tax (for example). If you are comfortable with a lower, but more stable and reliable return (the “sleep well at night” factor), then so be it.
As for me, when it comes to saving and investing for retirement, I am not sold on the benefits of whole life insurance over other more conventional options. However, I am increasingly convinced of the value of a “hybrid” approach to retirement planning that combines the benefits of both.
For example, those without access to an employer-sponsored retirement savings account may want to open an IRA and supplement it with a whole life insurance policy (or, instead, a deferred income annuity) after maxing out their IRA. Even if you have an employer plan, you might contribute just enough to get the company match and then supplement it with whole life insurance. A stable, predictable whole life policy may make you more comfortable investing most of your retirement savings in the stock market.
Whether that strategy makes sense for you depends on many factors, like your age, health, and overall financial situation. Make sure you understand all of your other investing alternatives first, including deferred income annuities. (But keep in mind that annuities don’t necessarily pay a death benefit; whole life policies do.)
Whole life insurance is not evil. As with most financial products, some whole life policies are good, and some are bad. The difference is in the details. Whether a good one is better than a competing alternative, such as a term life plan and investing in tax-deferred retirement accounts, is your decision. If you do your homework and decide the product’s benefits (tax advantages, asset protection, etc.) justify the price, then it’s the right decision for you.
It can be a good fit for an ultra-conservative investor who wants little or nothing to do with the stock market. Or perhaps someone looking for the flexibility a cash value account provides. It can also help wealthier people who have maxed out their retirement accounts and want to use it mainly as a tax shelter for additional savings or for estate planning.
If you decide to purchase whole life, the fine print matters, as with most sophisticated financial product documentation. Permanent insurance products are notorious for complex policy language, and deciphering them can be very difficult. Educate yourself, ask lots of questions, read the fine print, and talk to more than one insurance company before you make any decisions.