College – The Next Chapter: The Selection Process

Most of us know you can use assets in a retirement investment account or an annuity to generate income during retirement. But did you know you can use certain kinds of life insurance policies to do the same thing?

What kind of life insurance?

There are two primary types of life insurance: term and permanent. To use an analogy, think of a term policy as renting a home, and think of a permanent policy as buying a home. Similar to building equity in a home you are buying, permanent policies usually have a feature where they accumulate money inside them called Cash Value. In the same way that a mortgage payment is divided into principal (equity) and interest (the cost of the loan), the premium payment for a properly designed permanent life policy is divided into Cash Value (equity) and the cost of insurance (paying for the actual death benefit). In addition to your own money, the insurance company typically credits your policy with interest or dividends each year, so the Cash Value grows over time.

Note: There are different types of permanent policies (for example, Whole Life, Universal Life, Variable Universal Life, etc.) and they each have their plusses and minuses. Describing the differences would be lengthy and outside the scope of this article. For simplicity’s sake, I’m going to base the rest of this article on Universal Life.

So far, it sounds like an expensive savings account. What am I missing?

Using a life insurance policy to accumulate savings has some key differences from a savings account at your bank. First, the life policy offers tax deferred growth. In a bank savings account, you must report the interest you earn every year and pay income tax on it. The Cash Value in a life policy gets to grow tax deferred, just like in a qualified retirement account. Without having to pay taxes along the way, your money grows faster.

Second, the interest rate that an insurance company pays is typically much higher than the interest rate that a bank will pay on a savings account. For example, at the time of this article, the national average interest rate on a bank savings account is 0.06%1, whereas universal life policies typically average around 3%-5%.2

The biggest difference between Cash Value and a bank savings account has to do with taking the money out. With a bank account, you can only take out the dollars that are there, but there is a way to take money out of a life policy that is leveraged3.

OK, how do I get the money out?

Although the insurance company would allow you to simply withdraw the cash value, that option has a big drawback. The amount of gain in the policy (the current cash value minus the dollars you contributed along the way) would be taxed at ordinary income tax rates. There is a better option.

Insurance companies offer a way to borrow against the cash value in your policy. The proceeds from the loan are tax-free. It is important to note that you are borrowing against the cash value, not from the cash value. That means your entire cash value balance continues to earn interest. Contrast that with any other type of account, where when you withdraw money, the only portion of your money that continues to earn is the money remaining in the account.

Just as with most loans, you must pay interest on the amount you borrow. The life insurance company will typically charge 4%-5% interest. However, the cash value continues to earn 3%-5% interest, so your net cost for the loan might only be 0%-1%. No other vehicle I know of allows you to do this!

But when I’m retired, isn’t taking out a loan a bad idea?

Typically, we want to reduce our fixed expenses during retirement. And typically, adding a fixed loan payment to our retirement budget would indeed be a bad idea. However, taking a loan from your life policy doesn’t add any payments to your budgets. None. In fact, the insurance company doesn’t even expect you to repay this loan during your lifetime. At your death, the loan will be paid off from a portion of the death benefit, while the remainder will go to your beneficiaries. In a well-designed policy, your death benefit will grow over time. This should allow you to borrow tax-free income every year during retirement, pay off the loan when you die, and still have a sizeable death benefit remaining for your beneficiaries.

One small but important caution

What makes this entire strategy possible is the way life insurance proceeds are taxed. Loans taken against the policy are not taxed, nor is the death benefit taxed when received by your beneficiaries. If you take out too much money from the policy and don’t leave enough inside to pay the continuing cost of the policy, the policy will lapse (meaning the insurance company will cancel the policy). If that happens while you are still alive, then the IRS wipes out all of the tax benefits, and all that money you took out becomes taxable. That is a tax bill you want to avoid at all costs.

How do I add this strategy to my retirement plan?

Designing a policy correctly requires experience and advanced training. Many agents who only sell policies and don’t do financial planning may not be properly trained in the intricacies of this strategy. Make sure you get your policy from a reputable advisor who fully understands this strategy, and who can show you how it fits into the rest of your financial plan. This is not the kind of policy you want to buy over the internet or from an 800 number!

https://www.valuepenguin.com/banking/average-bank-interest-rates

Kelly, Patrick. (2007). Tax-Free Retirement

Dictionary.com defines leverage as “the use of a small initial investment, credit, or borrowed funds to gain a very high return in relation to one's investment, to control a much larger investment, or to reduce one's own liability for any loss.” http://www.dictionary.com/browse/leverage

Retirement is a big deal, and there are a lot of moving components to plan out. Those issues multiply when there is another individual added to the mix. My definition of retirement is the financial freedom to move into the next chapter of your life, and that next chapter is different for everyone –especially spouses! This is not the time to assume the two of you are on the same page or decide that the two of you will figure it out later. Most people know that I’m a big proponent of talking to your spouse about everything financial, and retirement is no exception.  Be sure to take the guess work out of this process so you can enter the next chapter of your life in harmony.

It’s not uncommon for couples to not see eye-to-eye on retirement. About half of couples don’t agree on what age to retire[i]. Less than 10% of surveyed couples retired at the same time[ii]. And 47% disagreed on how much they would need to save for retirement[iii]. With so many areas to disagree, from where to retire to how to spend your days, how do spouses work together to achieve their cumulative goals?

I always like to recommend the couples start off by taking my financial compatibility quiz. Not only does this show the areas you may not see eye-toe-eye on, but the quiz generates a lot of conversations. Continue these conversations at monthly financial date nights to make sure that the two of you continue on the same path towards the same goals. Talk about the details – at what age do you want to retire, how do you want to spend your days in retirement, and how much of that time will be spent together. Keep in mind that most people have spent over 40 hours a week away from their spouse for decades. Retirement frees up all that time, which can be too much “togetherness” for some couples. This is why I like to take my clients through a discussion on “your time, my time, and our time,” well before it is actually time for retirement. Discussing these things in advance can allow you to compromise on issues before emotions flair and make a world of difference between living together happily in retirement or, in worst cases, filing for divorce.

Once you have an idea of what your retirement goals are, you need to formulate a plan. An experienced financial planner can be a great resource at this time, bringing up things you may not have touched on and running “what if” scenarios for you to see how your retirement dreams can be converted into actionable goals. Please start these discussions early because financial independence takes many forms, but you can’t figure out when you’re going to get there until you plan your route.

Marriage is many things, but ultimately, it is a partnership. The two of you work together to move the household forward. You may not always agree, but you find common ground by talking and sharing and compromising. If you plan ahead and plan together, you can find the right way to your coupled vision of retirement.

Take our FREE Financial Compatibility Quiz here.

[i] https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/couples-retirement-fact-sheet.pdf

[ii] https://assets.aarp.org/rgcenter/general/retired_spouses.pdf

[iii] https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/couples-retirement-fact-sheet.pdf

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.