Life Insurance for Retirement: The Right (and Wrong) Approach

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In order to pursue a career in medicine, physicians make tremendous personal and financial sacrifices. With the average medical resident facing nearly $200,000 in debt, it is no wonder that most young physicians feel tremendous pressure to start earning quickly and establish financial independence.

As many doctors are busy establishing their career, starting a family, and building a nest egg, there is one aspect of long-term financial planning that often gets overlooked: retirement income tax liability. Most physicians understand the importance of saving up for retirement, but few physicians consider how their tax burden during retirement may impact their financial stability. Distributions from 401k plans and traditional IRAs are fully taxable. As a result, physicians who rely exclusively on these tax-deferred investments for retirement income are often unpleasantly surprised by their tax liability after retiring.

The best way to avoid an exorbitant tax burden during retirement is to balance your investment portfolio with assets that offer tax-free distribution. Common assets in this category include backdoor Roth IRAs as well as Roth 401(k)s and 403(b)s, however these investments are not available to all physicians and have restrictive contribution limits. This brings us to an alternative asset that can add long-term tax efficiency to your portfolio: a private pension using a life insurance contract for tax free accumulation and distribution.

When structured efficiently as a non-qualified executive benefit plan for a high-earning investor, the cash-value of a permanent life insurance contract can balance an investment portfolio and provide a source of tax-free retirement income. One of the common insurance contracts that are utilized for this purpose is indexed universal life insurance.

What is Indexed Universal Life Insurance?

Indexed universal life (IUL) insurance policies are complex insurance products in which the policyholder funds both a death benefit as well as cash-value within an equity index account. When you make your annual contributions into your insurance contract, a small portion of the money goes toward insurance costs, while the remainder builds up cash-value within the contract. This cash-value accumulates within an equity index account, growing tax-free in proportion to the performance of indexes such as the NASDAQ-100 or the S&P 500.

As the cash-value of the insurance contract grows, the account owner can withdraw 100% of the value that they put into the account tax-free. When the owner wants to withdraw beyond that amount, they can borrow from the gains within the account at a below market interest rate. These tax-free “loans” are actually advances from the contract’s insurance benefit. In this way, the owner can essentially pre-access the value of the tax free insurance benefit to provide tax-free income during retirement, gradually reducing the insurance amount that will be paid out at maturity. As long as the account is maintained until maturity, all withdrawals, advances, and payouts will not be taxed.

Avoiding Common Pitfalls of Life Insurance Contracts

As you explore the potential for using an insurance contract within your retirement plan, you may find that some financial professionals, such as the White Coat Investor, caution against this strategy. There is good reason to be especially prudent when considering the inclusion of one within your plan, as there are many wrong ways to approach this strategy. Pay too much in fees, and it will negate the growth of your cash-value. Put too much of your contributions toward insurance, and you lose out on cash-value. Pay too little towards insurance, and it will lose its tax benefits. However, when the flexibility of this kind of contract is used to the advantage of the investor not the insurance company, the result is a lean, efficient financial vehicle.

The average investor who approaches an insurance agent will be sold an off-the-shelf “retail” insurance contract, which typically includes unnecessary administrative charges, too much insurance, and gratuitous management fees. These inefficient “retail” contracts are not advisable retirement vehicles. However, a financial planner working in a fiduciary capacity can help you avoid these inferior products and construct a customized contract with compressed fees and can help you incorporate additional opportunities with premium financing. Think of this as the “wholesale” alternative to the retail product; it’s highly efficient and affordable, but more accessible to industry professionals than DIY investors. There are several proprietary options available through investor groups that traditional agents and advisors do not have access to. The proprietary options are the result of negotiations from investor groups getting more favorable terms through the investor groups for their clients.

The flexibility of IUL contracts is a double-edged sword. These products can be highly customized to strip down administrative expenses, accommodate different contribution schedules, and strategically allocate the money invested. Just don’t expect to find this type of the structure in an off-the-shelf life insurance policy. Most insurance agents do not work in a fiduciary capacity, and in fact profit off of selling bloated insurance policies. For this reason, it is absolutely critical to design your insurance contract under the guidance of an independent financial planner. A financial planner can perform extensive analysis of a contract design to test its efficiency and ensure that its structure maximizes returns for you, rather than the insurance company. To evaluate the efficiency of any investment, the investor and financial planner should look at the internal rate of return. It’s a specific measure of the true return, net of all fees and expenses. Finally, be wary of anyone who pitches life insurance as a magic, one-off investment solution for all your retirement needs. Like all financial products, a custom life insurance contract is most effective as an integrated component within a balanced retirement strategy.

Maintaining a tax-advantaged structure

When using an insurance contract for retirement planning, the structure is everything. A life insurance contract must be carefully designed to compress costs and maximize cash value without jeopardizing the investment’s tax-advantaged status.

According to Section 7702 of the U.S. Internal Revenue Code, any benefits (and loans) from life insurance plans are not subject to income tax. However, it also stipulates that in order to qualify as life insurance for tax purposes, a contract must maintain a certain amount of insurance protection above the accumulated cash value. This difference is known as the “corridor,” and it must be maintained in order to secure the tax-advantaged status of an insurance contract.

An efficiently designed executive benefit plan with an insurance contract should be structured to keep insurance costs as low as possible and the cash-value contribution as high as possible while still preserving the investment’s corridor. If the cash value enters into the corridor, it may fail to pass the corridor test and instead qualify as a modified endowment contract (MEC). MEC distributions are taxed as regular income and subject to early withdrawal fees of 10%. In short,  it is essential to preserve the funding ratio between your account’s insurance benefits and the cash-value to protect your investment’s favorable tax treatment.

No-risk investment growth

As an asset, the indexed universal life insurance contract provides a unique structure whereby it provides market growth while eliminating any investment risk. The financial institutions guarantee the cash-value of the insurance contract; this means that even in rare years when the index is down, your cash-value will never decrease from poor market performance.

While some critics argue that management and administration fees undercut the benefit of a life insurance contract’s cash-value growth, the historical strength of index performance suggests otherwise. Strong, consistent index performance over long periods of time have made cash-value life insurance one of the best performing assets on the market.

Conclusion

Using the cash-value of a life insurance contract for retirement income is not a one-size-fits all solution, and it is certainly not appropriate for every investor. However, for physicians who have already maximized contributions for their qualified retirement accounts and are looking for additional ways to accumulate wealth within their retirement plan, a cash-value life insurance contract is a strong vehicle to consider. When designed efficiently, the cash-value can provide an unparalleled source of tax-efficient retirement income and can take off the high income tax liability pressure of 401(k)s, traditional IRAs and other tax deferred investment vehicles.

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