In jumping into this topic, we are going to presume that you have read several of our other blog posts on retirement planning, such as The Tax Columns, How Much Does My 401K Save Me In Taxes, How Much Will My Social Security Be Taxed, and 4 Streams Of Tax-free Income.
For many, a Roth IRA offers a wonderful complimentary tool to help in creating tax-free streams of retirement income. In 2010, the limitation of who may convert from a traditional IRA to a Roth IRA was done away with, opening the door for this planning tool more than ever before. However, the Roth IRA still has several limitations that make it difficult to use as a widespread tax- free planning tool. Low contribution limits, age 59 ½ restrictions, income phase-outs that limit how much and if you can contribute at all, and the need for earned income in order to be able to contribute make the Roth difficult to use on a widespread scale for many other than a retirement supplement. Many of those limitations do not apply to Roth Conversions or to Roth 401Ks.
Now, this 4 part post is going to get very in depth about the Life Insurance Retirement Plan, complete with crediting strategy examples, how the IRS allows them to be tax-free vehicles, fees, pitfalls to watch out for, and much more. So turn off Netflix for the next little bit and grab a pen and paper.
A Life Insurance Retirement Plan (LIRP) can be a veritable Swiss Army knife of financial tools. The features of a properly structured LIRP often include:
- Tax-free access at any age—no age 59 ½ penalties
- No forced usage or RMDs
- No earned-income requirement in order to contribute
- No contribution limits
- Tax-free term insurance death benefit above and beyond the account value
- Long-term care provisions
All LIRPs have a tax-free term insurance policy that pays out to your heirs upon death. This is required in order for the values within the LIRP to be accessed without taxation, per the IRS rules. We will discuss exactly how that happens and the ease of use this awesome feature provides.
Most LIRPs nowadays also boast a long-term care provision, where you may use the tax-free death benefit during your lifetime if you should need long-term care, either at home or in a professional care facility. The most competitive policies offer this feature at no cost. If you don’t use the long-term care feature, great. Your kids/heirs receive the death benefit tax-free and you haven’t wasted money by paying long-term care premiums for a policy you ended up not ever using. If you end up needing long- term care (more than 50% of retirees do at some point, you can use the tax-free death benefit for that. Brilliant, right?We will also discuss this feature in detail.
What A LIRP is Not
No, this is not your lame duck, run-of-the-mill cash-value insurance policy that gives LIRPs a bad name. People often make a false equivalency, thinking a LIRP is the same kind of cash-value policy that their dad or some radio show host told them to avoid.
Those types of policies—whichdo not qualify as LlRPs—are often setup poorly by ignorant or ill-intentioned insurance agents who are not focused on tax-free retirement planning but rather maximizing their commission. Over 80% of fortune 500 CEOs use a LIRP as part of their over-all retirement planning strategy, as do a large amount of senators and congressmen, business owners, and wealthy families. Yet, it is not restricted to that type of clientele.
Most of the time, when purchasing life insurance, the idea is to get as much death benefit for as little premium (what you put into an insurance contract). With a LIRP, that gets turned on its head, where you put in as much premium as possible with as little death benefit attached to it as possible in order to minimize internal costs and maximize potential tax-free gains. We will also go through this in greater detail.
Like all retirement planning endeavors, the LIRP is a long-term strategy. If you’re retiring in 5 years, that does not mean a LIRP won’t make sense. Your retirement is likely to be 20-30 years long, which falls into a long-term perspective. If you’re in retirement already, a LIRP may or may not make sense depending on several factors, including when you would tap that portion of money in your LIRP compared to other retirement assets you have in a well-rounded retirement strategy.
NO, we do not love life insurance .We don't love any "product". We love strategies. We love tax-free retirement. We love the features of a properly structured LIRP. Many tax-free retirement strategies use a LIRP as part of the overall approach, and many don't. Who cares? So far, we have only two truly tax-free vehicles: Roths and LIRPs, properly structured. We’re into both of those because of their attributes and how they help facilitate tax-free retirement planning. If the government, in its vast wisdom, ever condescends to bestow upon us, lowly citizens, a third tax-free vehicle, we’ll probably be into that as well. Who cares what the product is called? What we need to care about is what it can potentially do for your retirement, mmkay?
What We All Want
What we all want from any financial vehicle, as far as attributes, can essentially be boiled down to three things:
- Reasonable Rate of Return
Early in my career, I was taught that you have to give up one in order to get the other two. For example, a bank account offers safety (so they say) and liquidity but is far from offering a reasonable rate of return. A mutual fund or stock offers liquidity and possibly a reasonable rate of return, but safety? Uh...moving on. An annuity might offer safety and a reasonable rate of return (watch out for the fees in variable annuities, ugh), but liquidity is going to be limited for a period of years. If I were to add a fourth criteria, it would be low fees, which is possible with any of the three products just mentioned.
I think this philosophy holds true most of time, that you will give up one in order to get the others. However, with a properly structured LIRP, you can get all four of those criterion, something that is not possible with other instruments. This can create safe yet productive tax-free returns toward your retirement efforts. We need both qualities. Obtaining a “safe” tax-free long- term average of 1% is hardly productive.
Three Different Types of LIRPs
In general, there are 3 different types of insurance policies that, when properly structured with a maximum funding construct, can function as a LIRP. It is invariably true that not all LlRPs are created equal. Later in this post, we will go through some attributes that should be sought after to make your usage of a LIRP the most beneficial it can be in your tax-free retirement planning.
- Interest Rate-based—This type of policy earns interest based on the current interest rate environment within the general account of the insurance company. If rates increase, your interest rate in this type of policy will also increase. The reciprocal is also true. In this extended low-interest rate environment, this type of policy has not been the most attractive. You might compare it to a CD earning a tax-advantaged return with a tax-free death benefit attached to it.
- Market-based—This type of policy makes use of mutual fund-type accounts, called subaccounts (essential mutual fund clones), that allow you to participate directly in the stock and bond markets. It is a security, and must be sold by prospectus, just like a mutual fund. When the market is doing well, these policies look attractive. However, when the market tanks, this style of LIRP can get into real trouble, which happened in the meltdowns of 2000-2002 and 2008. In light of that, many people now avoid these types of LIRPs despite their upside earning potential.
- Index-based—This type of LIRP allows you to participate in the upside of an equity index, such as the S&P 500, while protecting you completely from the downside (market losses). You might say it is a happy middle road between the first two versions, offering protection with respectable earning potential. All gains earned in a “segment period” (usually 1 year) are locked in automatically and contractually guaranteed against market-loss from that time forward.
Much has been said about the wisdom of using index funds (mutual funds or ETFs) because of their perceived low cost and the fact that the index itself more often than not beats managed funds’ performance on a long-term basis. Without picking a dog in this fight, let’s assume that the studies showing those claims are viable.
In doing so, if we base our potential earnings on the potential returns of an index, such as the S&P 500, we should have a solid foundation to begin with from a historical and efficiency perspective. Now, your money is not in the market (thank goodness) with this type of LIRP, but earns interest based on the market’s upward, and only upward, movements. For many people, we find this to be a superior long-term approach to linking your assets to an equity index.
In Part 2, we will discuss how the “engines” within LIRPs can potentially earn you respectable tax-free returns in preparation for being a critical part of your tax-free retirement strategy.
Kristen Cooper, NSSA®
Axios Capital Strategies