Role of Life Insurance in Retirement Plan

Life insurance is a crucial tool to help you provide for your loved ones when you pass away. While this is its primary function, it can be a way to help you financially during your retirement. Certain plans, such as a permanent policy, allow you to withdraw funds when you need them, such as for emergencies or during times of market volatility.

Using your life policy is not a substitute for other savings vehicles, such as a 401(k), Roth IRA, or pension. Rather, it can be a strategic tool when the situation merits it. In this article, we’ll outline how using life insurance during your retirement works and what to consider. This includes its benefits and drawbacks, as well as why you may want to consult with a financial advisor on when such a method is optimal.

Understanding Life Insurance

Life insurance is a contract between an insurer and a policyholder in which the former agrees to pay out a previously agreed-upon sum (also known as the death benefit) to a beneficiary. In return, the policyholder must pay premiums regularly or through one payment, depending on the contract. The purpose of life insurance is to provide for beneficiaries, such as a spouse or children, via the death benefit.

Typical life insurance policies come in two forms: term and permanent policies. The former covers beneficiaries during certain periods, such as 10, 20, or 30 years. Permanent life insurance, however, affords dependents lifelong coverage, as well as a cash value component that can grow tax-deferred over time. And, unlike term policies, the latter allows you to access these funds while alive.

To access the funds in a permanent life insurance policy, you can do one of the following:

• Withdraw. You may take out funds tax-free equal to the amount you’ve paid thus far. Withdrawing more will incur federal and, if applicable, state income taxes. This method can also decrease the value of your death benefit.
• Borrow. You may take out a loan against your policy’s cash balance, which often has lower interest rates than a typical personal loan. While this is helpful, unpaid loans (including accrued interest) will reduce your policy’s cash value and death benefit.
• Sell the policy. In some cases, such as through a life settlement, you can sell your policy to a third party for cash. This may not be an option unless your policy allows it.
• Surrender the policy. Like the previous option, you can forfeit your policy in exchange for a surrender payment from the insurer. The tradeoff, of course, is that you’ll no longer have a life insurance policy in place.

Before selecting any of the above options to get quick access to cash, we recommend speaking with a financial advisor. A professional can more easily determine which method fits your overall retirement plan.

How Life Insurance Works as a Retirement Income Source

Life insurance, while meant to cover your loved ones after you pass, can be a way for you to access a significant amount of cash during retirement. There are many different situations you might consider this option, such as during times of market volatility or due to emergency expenses.

Permanent life insurance plans are often referred to as Life Insurance Retirement Plans (LIRPs). Austin Rulfs, a Finance and Property Specialist at Zanda Wealth, explains that the primary benefit of these is that “unlike other retirement plans, the policyholder can borrow against this cash value in retirement, generating an income stream free from taxes.” He adds that, unlike “typical IRAs or 401(k)s, where early withdrawals may result in taxes and fees,” these policies give you “greater flexibility because you can access these assets as loans without incurring penalties.”

Here are key scenarios where it might make sense to leverage your life insurance policy during retirement:

1. Tax-Efficient Income

In retirement, withdrawing from tax-deferred accounts like traditional IRAs or 401(k)s can increase your taxable income. Using your life insurance policy as a tax-free income source—either by withdrawing up to the amount you’ve paid in premiums or borrowing against the cash value—can help you manage your tax burden and maintain financial flexibility. However, if you withdraw funds beyond the amount you’ve paid in premiums, the excess will be subject to income taxes.

2. When You Need to Pay for Emergencies

Unexpected expenses, such as medical emergencies, home repairs, or car troubles, can arise at any age. For retirees, these costs may be especially challenging if you rely on fixed income or need to avoid penalties for early withdrawals from other accounts. Borrowing against your life insurance policy often comes with lower interest rates than traditional loans, making it a potential option for covering urgent situations.

Understand, however, that, while borrowing against your policy can provide quick access to funds, it can impact your policy’s cash value and death benefit. Be sure to carefully consider the long-term effects of using your life policy, especially with the assistance of a financial advisor.

3. Periods of Market Volatility

During retirement, especially early on, you may own securities that significantly reduce in value due to market volatility. However, if an emergency occurs or your lifestyle warrants additional income, you’d end up taking those losses if you begin withdrawing funds from tax-advantaged accounts. Your life insurance policy can add a versatile income source during times when you’re reluctant to draw down other assets.

4. Additional Income for Early Retirement

Early retirement is a time when you’re primarily depending on your savings and investments to live. Typical income streams, like Social Security or your tax-advantaged accounts, may not be an option quite yet. In this case, having an additional source via your life insurance policy could be a consideration, especially if an emergency or sudden market shifts occur.

Pros and Cons of Using Life Insurance as Retirement Income

Using your life insurance policy to gain additional retirement income comes with a variety of advantages. Per Rulfs, “The key benefits of a LIRP include its tax advantages, such as tax-deferred growth and tax-free withdrawals when managed correctly. Additionally, it offers flexible access to funds, allowing you to borrow against the cash value as needed.” When you need cash quickly, such as for emergencies, life insurance can be a powerful tool.

While there are advantages, it’s also important to be aware of the downsides. First, life premiums can add up and be an added expense each month, especially for permanent plans. Monthly costs can be even more expensive for older individuals or those with healthy issues as well. Moreover, if you take out too much money from your policy, “you could deplete the cash value or lose out on some of the tax advantages,” cautions Rulfs.

Consult With a Financial Advisor on When It Makes Sense

When it comes to deciding whether life insurance makes sense within your retirement income plan, we recommend consulting with an experienced financial advisor. In your meeting with them, you can go over what other income sources you have and where using your policy could make sense. Additionally, a professional can help you understand and weigh the potential impact on your estate plan, especially if the policy’s reduced death benefit may not sufficiently cover your loved ones’ financial needs.

Finding a high-quality, fiduciary advisor is crucial. To find a professional near you, this free matching tool can help you. Once you fill out a brief quiz regarding your current financial situation and goals, it’ll connect you with a vetted expert that reflects your needs.