In this article, we are going to consider what role, if any, whole life insurance might play in your retirement income plan. Although the death benefit is still in view, the focus here is on leveraging the cash-value (investment) component to help fund your retirement income stream.

More and more retirement planning professionals are emphasizing that creative solutions will be needed to successfully fund a long time in retirement. Those with small to moderate amounts of savings will need to be especially flexible in how they set up their retirement income plans.

There is a school of thought known as the “safety-first approach” that 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 an increased role for various kinds of 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 been pushing the benefits of permanent insurance and annuities as retirement savings and income tools for a long time. However, they haven’t been widely embraced by the financial advisor community or consumers in general. That is beginning to change; planners and advisors are increasingly using a mix of risk-based assets (investments) and insurance-based products (life insurance and annuities) in the retirement income plans they construct 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 due to their complexity and cost, but they have gotten better. That said, cost and complexity remain a concern, so if you decide to go this route, perhaps adding them to a mix of Social Security and savings, make sure you understand what you are buying and what it will cost you.

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 know a little about how these products work so that you can make informed decisions about whether to purchase them or not.

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 a part of the retirement equation.

We know that retirement accounts like 401(k)s and IRAs have tax advantages. The most significant one is that contributions may reduce your taxable income in the year they are made, and they grow tax-free during the accumulation phase, adding to the compounding effect. Roth accounts offer tax-free withdrawals in retirement, but that is not the case for “traditional” (meaning that contributions were pre-tax) 401(k) and IRA accounts.

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 the death benefit is paid tax-free to your beneficiaries. (That is the case with term life as well, 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 the interest but don’t have to pay taxes on it.) As pointed out in the first article, it’s not that different than withdrawing from your banking account, but it is different than selling investment assets and paying the 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 appropriately managed, 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.)

Should you decide to cancel your insurance account and take out 100% of the funds, you may have to pay taxes on all the “tax-free” grains you ever received. Also, unlike retirement savings accounts, the cash accumulation in a whole life policy is not added to the death benefit and cannot be passed to heirs; in other words, the insurance company keeps it.

Policy withdrawals as income

There are several ways that whole life insurance can provide for some income flexibility in retirement.

First, the cash value of a whole life policy can be a source of income in retirement. Since it is guaranteed to grow (at a minimal rate) and is protected from market-related losses, it could be used to supplement retirement spending instead of having to sell 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 to have income that 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 that the “second to die” would have sufficient money to live on for the rest of their lives—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.)

It’s imperative when considering retirement income options with whole life to keep this important fact 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 making premium payments. That’s not a problem as long as you have a “paid-up” insurance policy. Then, they withdraw money (tax-free) from the policy and spend the proceeds as income. Still, not necessarily a problem. The problem comes in when the amount you withdraw from the cash-value account exceeds the amount you’ve paid in premiums—your cash basis. In that case, your gains will be taxed as ordinary income. Also, the death benefit will be reduced by the total amount you withdraw.

Instead of withdrawals, they 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 interest you don’t pay back 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 if you can’t afford to pay higher premiums to keep the policy in effect, or if you can’t afford to pay back the loan, the policy will be terminated. At that point, all of the tax-free withdrawals received 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 amount of the dividend depends on how much cash value you have and insurance company performance. (They invest in the same stocks and bonds that we do.) Dividends are not guaranteed (they aren’t with company stocks either), but most companies regularly pay them.

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 is only applied to the cash value, and it is unrelated to your actual return on your 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 have choices on 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 is what facilitates the tax-protected growth of the policy value and a slowly increasing death benefit. But they then switch to the “take them as income” later on when they need them as income in retirement.

Income annuities and life insurance

I have written extensively about annuities. Income annuities could have a place in many retirees’ retirement plans to help manage market and longevity risk. They pay “mortality credits” to people receiving payments who live beyond their average life expectancy since those who die early subsidize the payments to those who live longer.

There are some ways that whole life can be used in conjunction with 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 effectively uses the death benefit to replace the annuitized assets, which would then pass on to heirs (if that was the person’s intent in the first place).

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 that is made after their passing.

However,  positioning it in a way that enables them to then annuitize some assets while also preserving a death benefit for heirs may be more appealing.

Final thoughts

First of all, I want to say that I see nothing in purchasing a whole life insurance policy, regardless of your reason for doing so, 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 and the premiums are manageable, and you have generally been happy with the growth of its cash value, I would suggest holding on to it and using it to supplement your income in retirement or to leave a legacy to your heirs if that is your desire. If you want to leverage the cash value for other purposes, I think that fine too; just make sure you can pay it back if you want to retain the full death benefit.

If I needed a loan, and the cash was there in an insurance policy that I already had, I’d probably take advantage of it. That said, I’m not sure that I would recommend purchasing 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 that the investment component would be worth the higher premiums and are 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 also can lead to the obfuscation of unnecessary expenses. So separate the insurance from the investment so that you understand what it is costing and compare it to other 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 the benefits of whole life insurance over other more conventional options. However, I am also increasingly becoming convinced of the value of a “hybrid” approach to retirement planning that would combine the benefits of both.

For example, those without access to an employer-sponsored retirement savings account may want to consider opening an IRA and supplementing it with a whole life insurance policy (or, lieu of that, perhaps a deferred income annuity) after you have maxed out your 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. Having a stable, predictable whole life policy may make you more comfortable investing the bulk of your retirement savings in the stock market.

Whether that strategy makes sense for you will depend on lots of things, 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, there are good whole life policies, and there are bad ones. The difference is in the details. Whether a good one is a better option than a competing alternative, such as a term life plan and investing in tax-deferred retirement accounts, is the decision you have to make. If you do your homework and decide that the benefits of the product (tax advantages, asset protection, etc.) are justified by 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 who is looking for the flexibility that the cash value account provides. It can also help those who are more wealthy 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, as with most sophisticated financial product documentation, the fine print matters. 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.