Understanding How to Leverage Life Insurance Retirement Plans: Understanding LIRP Pros and Cons

Purchasing vacation homes, visiting grandchildren, traveling abroad, working a rewarding part-time job, or taking up a new hobby are all common goals for new retirees. The problem is most of these things cost money. In addition to your lifelong goals, unexpected medical needs or family crises may become an added expense during retirement. No matter what you choose to do for retirement, you need to be financially prepared.

Typical financial planning is failing most people even when they think they’re doing it right. Conventional retirement plans such as 401ks or IRAs were never meant to replace pension plans, but rather to supplement other retirement savings and income. If you are seeking financial security in your retirement years, you will likely need to pursue further wealth building strategies in addition to today’s typical retirement plans. 

KEY POINTS
  • Retirement Goals and Costs: New retirees often aspire to purchase vacation homes, travel, or take up new hobbies, all of which require financial resources. Additionally, unforeseen medical needs or family crises can also arise as unexpected expenses during retirement
  • Limitations of Conventional Retirement Planning: Traditional financial planning with instruments like 401(k)s or IRAs may not suffice for a secure retirement. These plans were designed to complement other savings, indicating a need for additional wealth-building strategies.
  • Role of LIRP Insurance: Life Insurance Retirement Plans (LIRPs) are a financial approach that supplements retirement income through a life insurance policy’s cash value, which can also act as a buffer during market volatility.
  • Functioning of an LIRP: LIRPs allow premium contributions to a life insurance policy, building cash value over time. This can be accessed via loans or withdrawals, with tax-free options available before and after age 59½. LIRPs are often overfunded to accelerate cash value growth.
  • Comparison with 401(k)s and IRAs: LIRPs, unlike 401(k)s, are individually managed and lack employer matching contributions. They offer more flexibility in contributions compared to the set limits in 401(k)s and IRAs and don’t require mandatory distributions like traditional IRAs.
  • Ideal Candidates for LIRPs: LIRPs are well-suited for individuals who have maximized their contributions to traditional retirement accounts, have a high net worth, or seek to diversify their retirement portfolio across various asset classes.

What is LIRP Insurance?

Life insurance retirement plan (LIRP) is a term used to describe a financial approach to supplementing your passive income in retirement with a life insurance policy. Because of its cash value accumulation, a life insurance policy can also be used as a buffer account for temporarily replacing passive income from invested accounts during market volatility in retirement. In this article, we will break down the different types of LIRPs, LIRP pros and cons, and how to decide if LIRP insurance is right for you.

How an LIRP Works

A Life Insurance Retirement Plan (LIRP) operates by allowing you to contribute premiums to a life insurance policy, leading to the accumulation of cash value over time. This cash value can be accessed through withdrawals or loans under certain conditions:

  • Prior to age 59½, you can withdraw or borrow money tax-free up to the total amount of premiums you’ve paid, known as the “basis.”
  • After age 59½, all withdrawals and loans from the policy are tax-free.
  • Upon your death, your beneficiaries receive the policy’s death benefit tax-free, though the benefit is decreased by any withdrawals or unpaid policy loans. If your main purpose for choosing an LIRP is to utilize its cash value, the reduction in death benefit might not be a significant concern.

LIRPs are typically “overfunded” policies. This means you can contribute more funds than what is necessary to keep the death benefit active. This additional investment accelerates the growth of the cash value, potentially boosting the tax-free income you can draw upon during retirement.

Understanding Loans in a Life Insurance Retirement Plan (LIRP)

A significant advantage of a LIRP is the ability to take out loans against the policy. As the cash value of your policy increases, you can borrow from it to enhance your retirement income, even before turning 59½. The procedure for this is quite straightforward:

  • Assess the total cash value available in your policy and decide the amount you wish to borrow.
  • Make a loan request to your insurance provider, and they will supply the requested funds.
  • Repayment terms are flexible, allowing you to repay the loan at your convenience. However, be mindful that an outstanding loan will decrease the death benefit of your policy, so it’s crucial to manage loans judiciously. Additionally, the insurance company will continue to levy policy charges. Should the cash value fall below a specified threshold, there’s a risk of policy lapse. In such scenarios, you might need to contribute additional premium payments to maintain your policy’s active status.

What Are the Different Types of Life Insurance Retirement Plans?

LIRP insurance is a life insurance policy used to build cash value to add supplemental income in your retirement years. Life insurance retirement plans come in the form of either universal or whole life insurance products and can be customized to fit your financial goals. If you are unfamiliar with the different types of LIRP insurance, here is a quick overview of whole life insurance and universal life insurance. See this article for further information on the types of life insurance.

Whole Life Insurance

Whole life insurance is a permanent life insurance product that will last the entire lifetime of the person who is insured and provide an income-tax-free death benefit to the beneficiary(ies) of the policy. Whole life insurance is the only life insurance product available today that develops equity for the policy owner. Participating whole life insurance is a type of whole life insurance that pays dividends when the insurance company generates a profit.

Universal Life Insurance

Indexed universal life and variable universal life insurance are two common types of universal life insurance. When using universal life insurance, the client assumes a lot more of the risk, and the insurance company can change many of the provisions in the contract. Unlike participating whole life policies, universal life insurance policies do not pay dividends. Both types of universal life insurance pay for the life insurance component through one-year term insurance. Because of this, universal life insurance is the more expensive type of insurance over a long period of time. These fundamental differences make whole life insurance better for long-term guarantees in LIRP insurance than any type of universal life insurance.

Cost of a Life Insurance Retirement Plan (LIRP)

The expense associated with an LIRP varies based on several elements:

  • Premiums: The cost of your premiums is influenced by the amount of coverage you select, along with factors like your age, health status, and other considerations. Typically, younger and healthier individuals are eligible for more affordable life insurance rates.
  • Fees: Owning an LIRP involves various fees, which can include administrative charges, expense fees, and surrender charges. When considering an LIRP, it’s advisable to request a comprehensive cost breakdown along with the policy illustration to fully understand the associated expenses.
  • Riders: LIRPs may offer additional features through riders, such as coverage for long-term care or disability income. Opting for these riders often results in higher premium costs.
  • Taxes: There can be tax consequences if you decide to surrender your policy or if you withdraw an excessive amount from it. It’s important to be aware of these potential tax implications when managing your LIRP.

What are LIRP Pros and Cons?

As with many things, life insurance retirement plans come with their own set of pros and cons. Recognizing advantages and disadvantages for LIRPs will give you greater context for making financial decisions.

Pros of LIRP Insurance

  • Security: LIRPs designed using whole life insurance come in very handy for retirees when the market experiences a turn for the worse. Instead of drawing income from their retirement accounts and destroying principal during market down years, they can use cash value provided by their LIRP.
  • No Contribution Limits: Choosing a LIRP along with traditional investments can provide additional advantages. Retirement plans, such as 401ks and IRAs, have contribution limits which cap the amount of money you can invest. LIRPs allow you to “contribute” higher premiums leading to greater cash value growth in the long-run. A LIRP is not always considered “better than” a 401k on its own, but depending on someone’s financial situation, an LIRP can provide more options and flexibility throughout life as you save for retirement. For this reason, LIRPs can be a great addition to many retirement strategies.
  • Access to Money: Most retirement plans impose an early withdrawal penalty. For example, if you take an early withdrawal from a 401k before the age of 59 ½ , you will pay a 10% penalty plus income tax. So, when can you withdraw from a LIRP? Anytime you like. With a LIRP, there are few restrictions on when you can access your accumulated value.
  • Dividend Payouts: With a whole life insurance policy, you have the opportunity to “participate” in the profits of the insurance company through dividends.

Cons of LIRP Insurance

  • Higher Premiums: In order to build the high cash value that policy-holders seek to leverage in a LIRP, such a policy will require decently-sized premiums. Without foresight, these premiums can be perceived as a disadvantage. However, the price of these payments is outweighed by the long-term benefits.
  • Lower Rates of Return: In some cases, LIRPs have a comparatively low rate of return to other investment vehicles with more risk. However, depending on your age and health, a whole life insurance policy can generate an internal rate of return (IRR) around 3-4% (premiums to cash value) over time. Older individuals can expect a lower overall IRR around 1-3%. Keep in mind that this Internal Rate of Return would need to be compared to a higher return in a typical financial investment, where the rate of return is reported before fees and taxes, for similar net results.
  • Premiums and Interest are Required: If premiums or interest on policy loans are not paid the policy could lapse. However, this con is within the policy owner’s control. With a knowledgeable agent and an organized approach, you should not have to worry about a policy lapse.

Comparing Life Insurance Retirement Plans with 401(k)s and IRAs

While Life Insurance Retirement Plans (LIRPs) are distinct from 401(k)s and Individual Retirement Accounts (IRAs), they can complement these retirement strategies, each having unique features.

LIRP vs. 401(k)

  • Employer-Sponsored vs. Individual Management: A 401(k) is an employer-managed retirement plan, often featuring automatic enrollment for employees. In contrast, an LIRP is a personally managed plan.
  • Matching Contributions: One of the key advantages of a 401(k) is employer matching, which can significantly enhance retirement savings. LIRPs do not offer such matching contributions.
  • Contribution Limits and Overfunding: 401(k)s have annual contribution limits set by the IRS (e.g., $22,500 for 2023), whereas LIRPs have no such caps, potentially allowing for greater retirement savings. However, overfunding an LIRP beyond the limits specified in tax code 7702 can convert it into a Modified Endowment Contract (MEC), changing its tax treatment.

LIRP vs. IRA

  • Taxation on Withdrawals: LIRPs offer tax-free withdrawals after age 59½, akin to Roth IRAs. Traditional IRAs, however, defer taxes until retirement withdrawals.
  • Contribution Limits and Potential Overfunding: IRAs have annual contribution limits (e.g., $6,500 or $7,500 for 2023, depending on age), while LIRPs do not. This allows for potentially greater retirement savings in an LIRP, but exceeding 7702 tax code limits can result in the LIRP becoming an MEC.
  • Required Minimum Distributions (RMDs): Traditional IRAs mandate RMDs during retirement, whereas LIRPs do not have such requirements, offering more flexibility in fund management. For Roth IRAs, RMDs start posthumously.

In summary, LIRPs offer a different set of benefits and flexibilities compared to 401(k)s and IRAs, making them a valuable addition to a diverse retirement planning strategy.

Who Would Benefit From a Life Insurance Retirement Plan?

A Life Insurance Retirement Plan (LIRP) might be a suitable option for you under certain circumstances:

  • Maxed Out Retirement Accounts: If you’ve reached your contribution limits in traditional retirement vehicles like 401(k)s and IRAs, an LIRP offers an alternative avenue to continue saving for retirement.
  • High Net Worth Individuals: For those with substantial assets, the death benefit from an LIRP can be strategically used to offset estate taxes, potentially sparing your heirs from having to liquidate assets to pay these taxes.
  • Seeking Diverse Retirement Investments: If you’re looking to broaden your retirement investment portfolio, LIRPs provide the flexibility to invest the policy’s cash value in various asset classes, such as stocks, bonds, and mutual funds. This diversification can be a valuable tool in comprehensive retirement planning.

Is LIRP Insurance a Good Investment?

Technically LIRPs are not investments at all since they are a guaranteed insurance product. Life insurance retirement plans can serve a number of purposes from financial peace of mind for families, to supplementary passive income in retirement. Many people can benefit from using life insurance as a part of their retirement planning. People who may recognize the greatest benefits from an LIRP include those who:

  • Realize standard retirement plans won’t be enough and want to be responsible for their future
  • Want to save more for the future and access cash value / savings along the way
  • Want more safety & guarantees for their financial future than they can get in the stock market 
  • Want more flexibility for their passive income and withdrawal strategies in retirement.

Final Thoughts

We all seek the peace of mind that comes with financial security. Proper planning can make your golden years much more enjoyable. We’d love to talk to you about how a life insurance retirement plan could work for you. Many advisors will pick their ideal financial strategy and ask you to plan around it. At McFie Insurance, we recognize that no one can predict the future (not even a financial advisor) and believe in tools that provide guarantees and options for your future so you can create the best financial strategy around your unique situation.

If you are interested in learning more, schedule a complimentary strategy session with us.

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