The life contingency annuity is, as we have said in previous articles, central to effective retirement planning, because it can provide income that cannot be outlived.

But life contingency annuities are only one element of an effective retirement plan. Another effective tool is life insurance. We prefer variable universal life insurance because clients can use this insurance to supplement their annuity, pension and social security income. This article will explore how this works.

Most retirement plans have a built-in assumption that income tax brackets will be substantially lower after retirement than before. Naturally, everyone hopes that will not come true–most of us would prefer to continue maximizing our income after retirement.

Regardless of the retirement planning assumptions, however, taxes will continue to be a factor for most retirees. Fortunately, life insurance may provide a continuing tax benefit that can help ease the burden in the retirement years.

As you know, annuity distributions are subject to a formula that determines how much of each annuity payment is taxable and how much is not. This “exclusion ratio” is established at the time of receipt of the first annuity payment, and it continues for the life of the contract or until the owners entire basis in the contract has been recovered. In most instances, the bulk of each payment will be taxable at ordinary income tax rates.

If the retirees income tax bracket is, in fact, lower than it was during the working years, this tax bite may not be a serious factor. However, if the income remains at relatively high levels, additional sources of tax-free income may be necessary. This is where life insurance comes in.

Life insurance that qualifies as a “non modified endowment contract” permits the policy owner to borrow against the life policys cash values without having to pay income taxes, so long as the policy stays in force. As a result, cash value life policies (particularly variable life policies that have performed well over the years) can provide a source of valuable tax-free funds to supplement other types of retirement income.

This suggests that, when approaching retirement, owners of such insurance would do well to review their life policy cash values. Then, they should obtain illustrations from the insurer or agent that demonstrate various possible levels of annual or periodic borrowings they can make over their remaining life expectancy.

However, remember that policies can vary in their policy loan provisions. Most cash value life policies, for instance, do permit loans of all or a large portion of the cash value. But VL policies typically limit the total loan amount to some percentage of total cash value at any time.

The limitation on variable life loans is designed to protect the insurer and policy owner against having the policy lapse when loans and market fluctuations exceed the amount of cash surrender value available. Such lapses can result in severe adverse federal income tax consequences, since the total amount borrowed in excess of the policy owners basis in the policy will be subject to federal–and probably state–income taxes, at ordinary income tax rates.

Fortunately, many variable life policies now include an “overloan” provision that should help. Such provisions state that, if there is an outstanding loan on the policy, the contract will not lapse in the event of market fluctuations. Instead, the policy will go into a form of non-forfeiture status until the insured dies. Generally, these provisions require that the remaining policy values be removed from the separate account and held in the insurers general account–essentially freezing the policy until death of the insured.

If an insurer wishes, it can obtain regulatory approvals to offer an overloan provision to existing variable life policies that did not have the feature at policy issue. The cost for the feature is modest and should be within the reach of most VL owners.

The use of VL insurance (or fixed life insurance for more risk averse clients) to supplement retirement income is well established. Moreover, large numbers of Americans already own cash value life insurance. That means financial advisors can immediately start helping clients understand and implement the methods for accessing policy cash values for tax-effective retirement income purposes.

What about life policy owners who are worried about outliving their available retirement but who do not have the necessary amount of annuities to ensure lifetime income? Financial advisors might consider recommending that these individuals exchange some of their life insurance for an annuity.

As you may recall, the Internal Revenue Code permits a tax-free exchange of a life insurance policy for an annuity. In the long run, such transactions will be less tax-effective than retaining the life insurance policy, since distributions from the annuity will, in part, be taxable. Nevertheless, for those concerned about longevity, the exchange will, in effect, be the purchase of insurance against living too long.

In sum, remember to consider life insurance as a key element in retirement planning. It can help consumers maximize retirement income while minimizing taxes.

Norse N. Blazzard, JD, CLU, and Judith A. Hasenauer, JD, CLU, are principals in the Ft. Lauderdale, Fla., office of Blazzard, Grodd & Hasenauer, P.C. E-mail them at Norse.Blazzard@BGHPC.com. Cary Lackenbach, president of Actuarial Strategies Inc., Bloomfield, Conn., contributed to this article.


Reproduced from National Underwriter Life & Health/Financial Services Edition, October 28, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.