How to Use Life Insurance for Your Retirement

Life insurance can be more than just a safety net for your family after you pass away – it can also serve as a retirement planning tool. Some policies build cash value that you can access in retirement, offering a supplementary source of funds. This approach may be a viable option for those looking to diversify their retirement savings, but there are important considerations to make before doing so.

A financial advisor can help you choose a life insurance policy with the goal of setting both you and your family for a secure future.

Understanding Life Insurance

Life insurance is a financial product designed to provide security by promising to pay a specified sum to a designated beneficiary upon the death of the insured person. The core purpose is to offer financial protection against the loss of income that would occur with the death of the insured.

In exchange for this protection, the policyholder pays regular premiums during their lifetime. The cost of these premiums depends on several factors, including the insured’s age, health and lifestyle as well as the amount of coverage.

Term vs. Permanent Life Insurance

There are two primary types of life insurance:

• Term life insurance offers coverage for a specific period, such as 10, 20 or 30 years. It's straightforward and generally less expensive than permanent life insurance, but it doesn't accumulate cash value. This type is often a common choice among those looking for temporary coverage, particularly during their working years when family and financial responsibilities are greatest.
• Permanent life insurance , including whole life and universal life, provides lifelong coverage and includes an investment component known as cash value. This cash value grows over time and can be borrowed against or withdrawn during the policyholder's lifetime. Although premiums for permanent life insurance are higher, the policy’s cash value can be a beneficial resource in retirement planning for certain individuals, offering an additional stream of income.

How Cash Value Accumulation Works

Permanent life insurance policies come with a cash value component that grows over time, tax-deferred. This feature is one of the main reasons people may consider using life insurance to save for retirement . You pay premiums into the policy, and a portion of that money goes into the cash value account. You can then access this cash value later in life to help supplement your retirement income.

The cash value grows based on the type of policy you have. Whole life insurance typically offers a guaranteed rate of return, while universal and variable policies may allow for more growth depending on the performance of investments linked to the policy. However, variable policies come with market risk.

Supplementing Retirement Income With Life Insurance

Life insurance saving for retirement can provide a tax-efficient way to supplement your income in retirement. The cash value component grows tax-deferred and loans taken from the policy are typically not taxed. This can be beneficial for retirees looking to reduce their taxable income or avoid drawing down other retirement accounts too quickly.

Additionally, unlike 401(k)s or IRAs , life insurance policies don't come with required minimum distributions (RMDs) , meaning you have more control over when and how you use the cash value in your policy.

Borrowing Against Your Policy for Retirement

One popular method of using life insurance for retirement is taking loans against the cash value of your policy. Since these loans aren't considered taxable income, they can be an attractive way to generate additional funds without incurring tax penalties. These loans are taken against the policy’s cash value and do not need to be repaid during your lifetime, but they will reduce the death benefit if not paid back.

Imagine a 70-year-old retiree who decides to borrow $30,000 from the cash value of their universal life insurance policy to help fund their grandson’s college education. They choose not to repay the loan immediately, using her other retirement income streams to cover her daily expenses.

However, handling these loans requires attention. If the total amount of the loan and interest grows too large, it could exceed the policy's cash value, risking policy lapse and potential taxes. As a result, the retiree keeps a detailed schedule to track the interest accruing on the loan and makes sure it doesn't exceed the policy's remaining cash value. This helps preserve their life insurance benefits and avoid potential tax issues.

Life Insurance Loan Risks

Taking loans against the cash value of your life insurance policy can offer flexible financing options, but it also introduces several risks that need careful consideration:

• Policy lapse: Borrowing excessively against the cash value can deplete the policy, leading to a lapse. If the policy lapses, the death benefit is lost and the loan balance may become taxable.
• Tax implications: While loans are generally tax-free, if the policy lapses or is surrendered with an outstanding loan, the IRS may treat the loan as taxable income.
• Interest accumulation: Loans accrue interest, which if not managed, can reduce the overall benefit of the policy.

Mitigating Life Insurance Loan Risks

Here are three general strategies to help you manage the risks associated with borrowing from your life insurance cash value:

• Regular monitoring: Keep track of your loan balance and cash value to make sure your policy stays active.
• Strategic repayment: Implement a repayment plan to manage the loan balance and minimize interest accumulation.
• Professional guidance: Consult with a financial advisor for strategies to integrate policy loans into your broader financial plan.

Downsides of Using Life Insurance for Retirement

Using life insurance for retirement income has its benefits, but there are drawbacks, too. Permanent life insurance policies can be more expensive than term policies, and the fees associated with maintaining these policies may cut into the returns you receive from the cash value.

There's also an opportunity cost . The money you put into a permanent life insurance policy may not perform as well as investments in stocks, bonds or other retirement accounts. If growth is your primary goal, life insurance may not offer the same level of returns as other investment vehicles.

Alternatively, you can buy a term life policy instead of a permanent policy, and invest the difference. This may help you build a larger nest egg to support your spending needs in retirement.

Bottom Line

Life insurance can serve multiple purposes, providing both a death benefit and, in the case of permanent policies, a potential supplemental retirement income through its cash value. By using life insurance for your retirement, you can use built-up cash value for loans or withdrawals without immediate tax implications. While this strategy offers flexibility and can complement other retirement savings, it's not for everyone. It also requires careful management to avoid depleting the policy’s value or incurring tax liabilities.

Life Insurance Tips for Retirement

• A financial advisor can help you integrate life insurance into a broader retirement plan. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now .
• If you want to know how much life insurance you may need, SmartAsset's life insurance calculator could help you find a personalized policy that meets your needs .

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