When planning for retirement, the majority of people place a primary focus on determining whether their accumulated resources will allow them to replace an adequate percentage of their pre-retirement earnings.
Research data, plus our own experience working with clients, consistently demonstrates that for those with higher incomes, the combination of Social Security and qualified retirement plan assets is less likely to adequately replace pre-retirement earnings, compared to those with lower incomes. In other words: even after they’ve maximized qualified retirement plan savings and accounted for Social Security, higher income earners may need additional savings to achieve their income replacement objectives and support their ideal retirement lifestyle. The graph below summarizes this point:
One obvious question for high-income earners is, what saving vehicles make the most sense? We frequently advise our clients to allocate their savings among three types of vehicles, based on their respective tax treatments: tax-deferred, taxable and tax-favored.
A quick breakdown
Tax-deferred vehicles are those in which there is a current deduction for contributions; taxes on investment results are deferred; and distributions are taxable. Individual retirement accounts (IRAs), 401(k) plans and SIMPLE IRA plans are the primary tax-deferred vehicles. It generally makes sense for high-income earners to maximize savings in these vehicles to whatever level is permitted under the law.
Taxable vehicles are those in which contributions are not tax-deductible; taxes on investment results are paid as gains are realized; and distributions are generally subject to potential capital gains or ordinary income taxes. Stocks, bonds, mutual funds and real estate are the primary taxable investment vehicles.
Tax-favored vehicles are those in which contributions are not tax-deductible; taxes on investment results are deferred; and in general, distributions are tax-free. Roth IRAs and cash value life insurance policies are among the primary tax-favored vehicles.
In some cases, high-income earners may be interested in utilizing tax-favored vehicles as part of their retirement savings strategy, but find that they are phased out of making contributions to Roth IRAs under annual adjusted gross income (AGI) limits. The alternative for these savers, after exhausting all tax-deferred options, is often cash value life insurance.
Is a cash value policy right for you?
Life insurance as a retirement accumulation vehicle is not a new idea, but relatively recent changes in product design — especially for variable universal life (VUL) insurance products — have made it a more attractive proposition for high-income earners. Here are characteristics to consider when evaluating the cash value life insurance option:
There is no legal limitation on contributions, although high-income earners must take care to prevent the life insurance policy from becoming a modified endowment contract (MEC).
Investment returns on cash value life insurance accumulate on a tax-deferred basis.
Modern VUL insurance policies typically have a wide array of investment options; these are commonly known as “separate accounts,” which closely mimic publicly traded mutual funds, exchange-traded funds (ETFs) and index funds. With many products, high-income earners can construct a well-diversified portfolio of equity and fixed-income investments from the hundreds of options available. The resulting portfolio will typically match up with the asset allocation reflected in the high-income earners’ other retirement savings vehicles.
As retirement funds are needed, high-income earners can withdraw cash values income tax-free up to the policy’s tax basis (generally the sum of premiums paid on the policy) or take a loan against the cash value policy itself. A loan against a policy does not trigger immediate taxation and is “netted out” of the policy’s income-tax-free death benefit at the passing of the insured.
Unlike other savings vehicles (think traditional IRAs), there is no minimum age requirement for accessing life insurance policy values without tax penalties, and there is also no minimum age requirement for taking distributions.
Many variable life insurance products offer “preferred” or “wash” loan provisions, which minimize the borrowing cost of accessing the cash value. When policy values are borrowed, the insurance company holds them in a collateral account, and then lends the owner the specified amount.
In a preferred loan arrangement, the interest credited by the insurance company on the collateral account is slightly lower than the interest charged on the loan balance (typically 0.25- to 0.50-percent APR). In a wash loan arrangement, the interest rate credited on the collateral account is the same as the rate charged on the loan balance.
A number of modern variable life insurance products include an “overloan protection rider,” which is designed to protect the owner from borrowing so much from a policy that it lapses for failure to repay a growing loan balance. If an owner allows a policy with loans against it to lapse in retirement, there’s a tax trap: all amounts the owner receives in excess of the policy’s tax basis will be deemed as ordinary income, distributed to the owner. To avoid that fate, the overloan protection rider “freezes” the policy once the loan balance reaches a specified percentage of the policy’s cash value. The frozen policy value and death benefit will then remain in force until the owner’s death, at which time the loan is netted from the death benefit.
What to watch out for
For some high-income earners, there can be drawbacks to selecting life insurance as an alternative retirement savings vehicle. The most notable obstacle is that the inherent costs of life insurance — including mortality charges, premium taxes and sales charges — are a drag on returns. Generally, the strategy makes the most sense for relatively healthy savers, who can qualify for a standard or better premium rate class to minimize the cost-of-insurance drag.
In addition, high-income earners can structure the policy to provide the smallest death benefit permitted under Section 7702 — without causing the policy to become an MEC — which will help minimize the drag on performance. For many high-income earners, the net-of-tax results of the cash value life insurance vehicle will be better than the net-of-tax results of a taxable investment vehicle, assuming comparable gross investment returns.
A sound retirement savings and drawdown strategy is often the result of consulting with a fiduciary financial advisor. If you have exhausted your tax-deferred savings options, sit down with your advisor and ask if adding a tax-favored vehicle like cash value life insurance makes sense for your situation. And one more tip: ask your advisor if you should reduce or change any of your other life insurance coverages after adopting the new cash value life insurance plan. With the right strategy in place, you can successfully sock away more savings for retirement and continue on the path toward achieving your goals.
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