Wealthy clients whose income excludes them from some familiar retirement plans have another choice for money later in life, one that offers distinct tax advantages but requires care in setting up.
A life insurance retirement plan (LIRP) is a type of insurance policy that, though not a complete substitute for an IRA or a 401(k), has a cash value component for retirement money. That cash value grows tax-deferred and some withdrawals can be tax-free; wealthy clients can use the death benefit to pay estate taxes.
“Often clients and professional advisors are unaware this investment exists,” said Kory Leadon, Scottsdale, Ariz.-based senior lead advisor at Brighton Jones, a large RIA with $26 billion under advisement in Seattle. “When they hear ‘life insurance,’ they think of their father’s old whole life policy.”
LIRPs’ advantages depend on overfunding the policy. “This is a way to pay too much in premiums that can eventually be taken out as a loan against the policy tax-free,” said Leah Schwarz, managing director and wealth manager at Perspective Wealth of Steward Partners in San Antonio. “LIRPs can be utilized for long-term care, vacations or just supplemental income in retirement.”
Leadon said LIRPs are complimentary tools to core retirement investment components. “For certain clients, the LIRP strategy works as a complement to their brokerage account and other retirement assets,” Leadon said. “Distributions can be taken at any age and in any manner the client chooses. It’s not a locked-in series of equal payments like an annuity.”
LIRPs generally come with a flexible and tax-free death benefit covered by the overfunding, with the excess also contributing to a cash value savings account. This account, which grows tax-free, can be invested with tax-advantaged loans and withdrawals used to later access the cash for retirement. Though resembling Roth IRAs in that after-tax dollars are invested initially while earnings and distributions are free of income tax, LIRPs have no income caps.
A successful LIRP strategy requires that the insured be in average or better health and have other sources of liquidity for the immediate future. “LIRP strategies typically need the funds to be invested seven-plus years before distributions are received,” Leadon said. “While they can access the cash value any time, the strategy works best when the funds have time to grow and compound in this tax-deferred environment.”
In many cases, Leadon said, the client funds the policy with cash on hand. “It could [also] be possible that the client plans to liquidate a portion of their brokerage account investments to fund premiums, so in that case they should first consider the tax impact,” Leadon said. “Certain insurance products have shown historically that their risk is compatible to that of a bond fund while their returns may be closer to that of a diversified brokerage account. We can utilize a portion of their assets that would normally be designated for bonds and reallocate those funds into a LIRP strategy that may produce greater retirement income."
Price-shopping for policies is key to avoid a drain on the cash value, advisors said. Schwarz also warned that LIRPs should be reviewed to ensure clients don’t overfund too much and create a modified endowment contract (MEC)—a cash value life insurance policy that has been so overfunded that it to lose its tax benefits and is treated as an investment by the IRS.
“The tax-free death benefit does count as an asset of the policy owner’s estate, so if the client has a taxable estate, the death benefit would increase the amount of that tax,” Leadon said. “LIRP strategies are designed to have minimal death benefits in the later years, and clients could also implement some basic planning strategies to move the asset outside of their taxable estate.”