Can Life Insurance Be Used for Retirement?

Life insurance policies primarily provide a financial safety net for beneficiaries after the policyholder’s passing. However, certain types of life insurance can also accumulate cash value during the policyholder’s lifetime. This cash value may be accessed, offering a potential resource for various financial needs, including supplementing retirement income.

Foundational Concepts of Cash Value Life Insurance

Cash value in a life insurance policy represents a portion of the premium payments that grows over time, separate from the death benefit. This accumulated amount can become a significant financial asset that policyholders may access during their lifetime. The growth of this cash value is typically tax-deferred, meaning taxes on the earnings are not due as long as the funds remain within the policy.

The way cash value grows depends on the specific type of permanent life insurance. Whole life insurance offers guaranteed cash value growth at a predictable interest rate, with fixed premiums that do not increase over time. Policyholders may also receive dividends, which are a share of the insurer’s profits, potentially increasing the cash value or reducing premiums.

Universal life (UL) insurance provides more flexibility, allowing adjustments to premiums and the death benefit within certain limits. The cash value in a UL policy grows based on an interest rate set by the insurer, often with a guaranteed minimum rate, and can fluctuate more than whole life cash values. A portion of each premium covers the cost of insurance and administrative fees, with the remainder contributing to the cash value.

Indexed universal life (IUL) insurance links cash value growth to the performance of a market index, such as the S&P 500, without direct market investment. IUL policies include “caps” that limit the maximum interest rate and “floors” that guarantee a minimum return, often 0% to 1%, protecting against market downturns. This structure allows for potential higher returns than traditional UL, while offering some downside protection.

Methods for Utilizing Policy Cash Value in Retirement

Policyholders can access the accumulated cash value in their permanent life insurance policies through several methods during retirement.

Policy Loans

One common approach is taking a policy loan, where the policy’s cash value serves as collateral. These loans generally do not require credit checks and offer flexible repayment terms. Any outstanding loan balance will reduce the death benefit paid to beneficiaries.

Withdrawals and Partial Surrenders

Direct withdrawals from the cash value reduce the policy’s cash value and the death benefit. Partial surrenders are similar, allowing access to a portion of the cash value while keeping the policy in force, though they can also impact the death benefit or policy face amount.

Full Surrender

A full surrender involves canceling the coverage entirely to receive the cash surrender value. This terminates the life insurance policy, eliminating the death benefit and any future coverage.

Annuitization

Some policies may also offer the option to annuitize the cash value, converting it into a stream of regular income payments, similar to an annuity.

Tax Treatment of Policy Funds Used for Retirement

The cash value within a life insurance policy grows on a tax-deferred basis. Policyholders generally do not pay taxes on the earnings as they accumulate, allowing the cash value to compound more efficiently.

Policy Loans

Policy loans are typically not considered taxable income as long as the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the premiums paid can become taxable income. This can lead to an unexpected tax liability.

Withdrawals

Withdrawals from a life insurance policy are generally taxed under a “first-in, first-out” (FIFO) rule. Withdrawals up to the amount of premiums paid into the policy (known as the cost basis) are usually tax-free. Any withdrawals exceeding the cost basis are generally taxed as ordinary income.

Full Surrender

If a policy is fully surrendered, the difference between the cash surrender value received and the total premiums paid is considered a taxable gain. This gain is subject to ordinary income tax.

Modified Endowment Contract (MEC)

A policy becomes a Modified Endowment Contract (MEC) if premiums paid exceed certain IRS limits, specifically failing the “7-pay test.” Once a policy is an MEC, its tax treatment changes permanently. Withdrawals and loans from an MEC are taxed on a “last-in, first-out” (LIFO) basis, meaning earnings are considered withdrawn first and are immediately taxable as ordinary income. Additionally, withdrawals from an MEC before age 59½ may incur a 10% federal penalty tax on taxable gains.

Key Characteristics for Retirement Planning

Cash value life insurance offers several characteristics relevant to a comprehensive retirement plan.

Tax-Deferred Growth

The policy’s cash value grows tax-deferred, allowing earnings to accumulate without annual taxation. This provides an environment for wealth accumulation.

Death Benefit

These policies include a death benefit, providing financial protection for beneficiaries. This means the policy offers a potential source of retirement income while also ensuring a payout to loved ones. The death benefit is generally paid income tax-free to beneficiaries.

Liquidity

Policyholders have access to the accumulated cash value through loans or withdrawals, offering liquidity. This access can provide financial flexibility for unforeseen expenses or supplemental income during retirement, often without the age-based restrictions found in some other retirement vehicles. However, accessing cash value reduces the death benefit.

Predictability and Stability

For certain policies, like whole life, cash value grows at a guaranteed rate, providing predictability not tied to stock market performance. Indexed universal life policies, linked to market indices, often include “floors” that protect against market losses, ensuring cash value does not decrease due to negative market performance. These features can offer a measure of stability in a diversified retirement portfolio.

Supplemental Income Source

Utilizing cash value life insurance can serve as a supplemental income source alongside traditional retirement savings, such as 401(k)s and IRAs. It can enhance financial security and provide additional options for funding retirement years, complementing rather than replacing other retirement assets.