Rosalind Evans
Indexed Universal Life (IUL) insurance policies can potentially assist in mitigating taxes and augmenting retirement income, apart from providing death benefits to your heirs. When considering retirement plans, people often focus on traditional retirement savings tools like 401(k) plans, IRAs, and Social Security benefits. Life insurance products are frequently overlooked, perhaps due to their primary purpose of providing death benefits rather than seeming like adequate retirement income or tax planning instruments.
But, some types of life insurance, particularly cash-value products such as an IUL, can also be potent resources for retirement, granted that you meet the required health and financial eligibility for the coverage and the anticipated benefits justify the policy costs. This article will delve into how IULs can boost your retirement income.
Generating Retirement Income with an IUL, There are several ways to organize retirement income. Many individuals manage their portfolios and extract assets from non-qualified accounts while staying within a certain tax bracket to keep their taxes low. Others choose to earn income up to a limit to prevent pushing into the following income tax bracket. In this context, an IUL might be a source of tax-free income.
The strategy is to invest in an IUL and let it grow for a certain period, ideally at least ten years. If the policy performs favourably, its cash value can be used as additional income without triggering extra income taxes. Positive arbitrage over time can result in extra income to relish during retirement or as a tax-free inheritance for your heirs.
However, remember that policy loans and withdrawals will reduce the available cash values and death benefits, which could lead to the policy lapsing or affect any guarantees against lapse. Additional premium payments may be necessary to maintain the policy. In case of a setback, outstanding policy loans exceeding the unrecovered cost basis will be taxable.
The complexity of IULs underscores the importance of working with a trusted financial adviser. These policies must be appropriately designed, funded and managed to ensure effectiveness. This article aims to introduce potential strategies that could be integrated into your retirement plan. Every investment is flawed, so it’s essential to thoroughly research and understand any potential drawbacks before purchasing a policy.
Here are three strategies for deriving retirement income from indexed universal life insurance:
- Conversions from IRA to IUL
- Moving a traditional IRA to a Roth IRA is a common strategy for minimizing taxes, leading to tax-efficient income later in your retirement. You can convert in three ways. The first involves transferring your IRA funds into a Roth IRA and paying the taxes on the transferred amount at the current income tax rates.
The second is the backdoor Roth IRA. If your income exceeds a certain threshold, you may not be able to contribute directly to a Roth IRA. In this scenario, you can contribute to a traditional IRA, then convert those assets to a Roth IRA later. While there are contribution limits for traditional IRAs, there are no restrictions on the amount you can convert from an IRA to a Roth IRA.
The third is the mega backdoor, Roth, typically within your 401(k). Not all plans allow this conversion, so consult your plan administrator for details.
There’s also a method to strategically shift pre-tax assets into tax-free accounts, specifically the IUL. This involves gradually withdrawing funds from your 401(k) or traditional IRA as distributions and using them to pay the premiums on a life insurance policy. Once the funds are transferred into the IUL, they will be subject to income tax as they qualify as a distribution.
Although the initial thought of paying taxes to move funds from a pre-tax account into an after-tax account may seem daunting, the strategy aims to generate positive arbitrage over several years. If the policy performs well, you may recover some of the taxes paid.
Consider investing pre-tax funds into a fixed or fixed-indexed annuity or CD, structuring it to grow while arranging distributions from the pension each year to pay premiums on the life insurance policy. These distributions will be taxable when withdrawn from the IRA annuity and should generally be taken after age 59½ to avoid penalties. This allows all funds to grow and ensures principal protection while systematically funding the IUL to achieve the IRA-to-IUL conversion strategy.
Pension Protection Against Possible Income Tax Hikes
This is admittedly the more risky strategy of the three. The goal is to serve as a potential buffer against higher tax rates. Higher taxes could impact your lifestyle affordability if your pension or pre-tax annuitized income stream is your primary income. This strategy’s success depends on time and potential performance, which isn’t guaranteed. For instance, investing in an IUL with after-tax funds for at least five years is ideal and letting it grow for at least another five years. You should also aim for an adequate death benefit to cater to your legacy needs while minimizing insurance fees. Any additional riders that could increase the cost of insurance could derail the strategy’s purpose.
If the policy is effectively set up, funded, and yields successful growth, achieving positive arbitrage, it might help offset the income taxes due on your pension payments through tax-free loans from the IUL.
It’s important to remember that the policy won’t fully cover the taxes on your pension payments. An IUL typically guarantees an interest rate of 0% to 0.1% at best. So, in years when the selected index does not yield any interest, you will need to arrange for funds to cover taxes and possibly the loan interest on the IUL. This could come from that year’s pension income or additional policy loans.
However, if taxes don’t increase and you don’t need to use the policy to guard against rising tax rates, you can still utilize the IUL for tax-free income during retirement and pass any remaining funds to your heirs tax-free. At the very least, it could be a functional part of your retirement plan.
Concluding Thoughts Indexed universal life insurance can serve a dual purpose, providing a critical death benefit to your beneficiaries while potentially augmenting your retirement income. However, remember that no investment or product is flawless. Each has its advantages, costs, and limitations. Collaborating with a financial adviser and a CPA or enrolled agent can assist in determining whether an IUL might be a beneficial addition to your financial strategy.
