Is Life Insurance a Retirement Plan?

Life insurance is primarily designed to provide a death benefit to beneficiaries, offering them financial protection. In contrast, a retirement plan is built to generate a stream of income for an individual during their post-employment years. The confusion between the two stems from how certain insurance products are structured.

The overlap occurs because some permanent life insurance policies contain a savings component that can accumulate money. This feature has led to a strategy of using life insurance to supplement retirement savings, often called a Life Insurance Retirement Plan (LIRP). A LIRP is not a formal retirement plan like a 401(k), but a method of using an insurance contract to help fund retirement.

The Cash Value Component of Permanent Life Insurance

The cash value component is a feature exclusive to permanent life insurance that allows it to function as a savings vehicle. Unlike term insurance, which only provides a death benefit for a specific period, permanent policies are designed to last a lifetime. A portion of each premium payment covers the cost of insurance and fees, while the excess is deposited into a cash value account.

The growth of this cash value varies by policy type. In a whole life insurance policy, the cash value is guaranteed to grow at a minimum fixed interest rate. These policies may also earn annual dividends, which are not guaranteed but can be credited to the cash value, used to pay premiums, or taken as cash.

Universal life (UL) insurance offers more flexibility, allowing policyholders to adjust premium payments. The interest credited is tied to market rates but includes a minimum guarantee. Variable universal life (VUL) insurance allows the policyholder to invest the cash value into sub-accounts similar to mutual funds. This approach links performance to the market, creating the potential for higher returns but also the risk of loss.

Methods for Accessing Funds from a Life Insurance Policy

Once sufficient cash value has accumulated, the policyholder has several methods for accessing these funds. Accessing this money can have significant consequences for the policy’s death benefit, and each method impacts the policy differently.

The most common method is taking a policy loan. This is a loan from the insurance company using the cash value as collateral, so the funds are not removed from the account, which continues to earn interest. Interest accrues on the loan, and if not repaid, the outstanding balance is deducted from the death benefit.

Another method is a withdrawal, also known as a partial surrender. This involves permanently removing a portion of the cash value. Unlike a loan, this action is irreversible and reduces the death benefit by at least the amount withdrawn. The remaining cash value is also permanently lowered, which can impact future growth.

A full surrender of the policy terminates the insurance contract. The policyholder receives the net cash surrender value, which is the total accumulated cash value minus any outstanding loans and applicable surrender charges. Surrender charges are fees imposed by the insurer, typically in the early years of a policy.

Tax Treatment of Life Insurance Funds

The tax rules governing life insurance are a reason these products are considered for retirement savings. The cash value within a policy grows on a tax-deferred basis, meaning the policyholder does not pay annual income taxes on the gains as they accumulate. This allows the funds to compound more efficiently.

When accessing funds, the tax implications depend on the method used. Properly structured policy loans are received income tax-free. Since the loan is a debt against the policy rather than a distribution of income, the IRS does not consider it a taxable event. This allows access to cash value without an immediate tax liability.

For withdrawals, the tax treatment follows a “First-In, First-Out” (FIFO) basis. This means withdrawals are first considered a return of the policyholder’s premium payments, known as the cost basis, and are tax-free up to that amount. Only after the entire cost basis has been withdrawn do further distributions become taxable. The death benefit is received by beneficiaries free of federal income tax.

An exception to these tax rules is when a policy becomes a Modified Endowment Contract (MEC). A policy is classified as a MEC if it is funded with more money in its early years than allowed under federal tax law. If a policy becomes a MEC, distributions are taxed on a “Last-In, First-Out” (LIFO) basis, meaning gains are taxed first. Distributions from a MEC, including loans, may also be subject to a 10% penalty if taken before age 59 ½.

Comparing Life Insurance with Traditional Retirement Accounts

Comparing life insurance with traditional retirement accounts like 401(k)s and Roth IRAs reveals differences in purpose, cost, and rules. The main purpose of life insurance is providing a death benefit, while a retirement account’s sole purpose is funding retirement. Key distinctions include:

• Contribution Rules: For 2025, IRA contributions are limited to $7,000, while 401(k)s are capped at $23,500, with catch-up contributions allowed for those 50 and over. Life insurance has no official IRS contribution limit but is constrained by rules to avoid becoming a Modified Endowment Contract (MEC).
• Tax on Contributions and Distributions: Life insurance premiums are paid with after-tax dollars, similar to a Roth IRA. Traditional 401(k) or IRA contributions are made with pre-tax dollars. For distributions, qualified Roth IRA withdrawals are tax-free, while traditional 401(k)/IRA withdrawals are taxed as income. Life insurance allows tax-free access through loans or withdrawals of the cost basis.
• Investment Options and Costs: A 401(k) or IRA offers a wide array of mutual funds and other securities. While some life insurance policies offer investment sub-accounts, others have more limited, managed growth potential. Life insurance policies also carry costs unrelated to investment, including the cost of death benefit coverage, commissions, and administrative fees, which are higher than typical retirement account fees.
• Accessing Funds: Taking money from a life insurance policy in its early years can trigger substantial surrender charges. For retirement accounts, early withdrawals before age 59 ½ usually result in a 10% penalty on the taxable portion of the distribution. With a Roth IRA, contributions can be withdrawn tax- and penalty-free at any time, with the penalty only applying to the earnings portion of an early withdrawal.