The primary factor that makes life insurance a potential retirement savings option is the tax favored status afforded life insurance. With proper policy design, the buildup of cash value in the policy is not subject to taxation, and most policy distributions are not subject to tax provided the policy remains in force until death. The taxation of life insurance, when properly designed and monitored, is much like that of a Roth IRA. Banks have utilized cash value life insurance for years to enhance their after tax rate of return.
The benefit of life insurance as a retirement planning investment is primarily dependent on two factors. These are the cost associated with the life insurance product, and the tax rate applicable to an equivalent investment option that does not have the tax favored status of life insurance.
For example, assume that investment return of a universal life or indexed life insurance product is 5%, and that the projected policy distributions result in a 3.20% rate of return on premiums paid. The bottom line is that over time, the costs associated with the policy reduce the return by 1.80%. It is important to remember that the primary component of this cost is life insurance protection, a component that is provided only with life insurance.
If we assume this same 5% rate of return is invested subject to tax, two factors will reduce the assumed return. The first is management fees that are applicable to the investment, and the second is the combined federal and state income tax rate that reduces the return. If we assume a management fee of 80 basis points, and a combined federal and state income tax rate of 24%, the net return is the same 3.2%. In this example, for each 1% increase in the applicable tax rate above 24% the net after tax rate of return is further reduced by 42 basis points. As a result, if the applicable tax rate is 43%, the net after tax rate of return is 2.4%.
Life insurance as an investment for retirement does not stack up as well against qualified plan savings, so be sure to full fund these types of plans first.
There are a lot of trusts that have significant investment income, and the use of cash value life insurance as one of the trust investments is an option that should be considered. More on this in my next blog.
If you would like more information on this subject, or have a client who might benefit from a discussion about it, please contact Barry Koslow at bkoslow@mkaplanners.com or (781) 939-6050.
Securities offered through Advisory Group Equity Services, Ltd., Member FINRA/SIPC. 444 Washington Street, Woburn, MA 01801 (781) 933-6100.
© MKA Executive Planners, 12 Gill Street, Suite 5600, Woburn, MA 01801 800-332-2115
photo credit: moolanomy via photopin cc