Asset allocation in retirement income planning is perhaps one of the most fundamental concepts to ensuring sufficient retirement income while maximizing the growth potential of a client’s assets. While equities, bonds and cash equivalents are some of the traditional asset classes, or buckets, that advisors seek out in designing any given client’s allocation strategy, a new asset class has emerged that may add even greater value for some clients—indexed universal life insurance (IUL).
For the right client, IUL can represent a type of hybrid combination of some of the more traditional asset classes—providing the conservative risk protection elements of a bond along with equity market participation and potential access to tax-free cash later in retirement.
IUL: The Retirement Planning Tool
Indexed universal life insurance policies are cash value life insurance products that are tied to a specific stock index–such as the S&P 500–and provide returns based upon a formula that is tied to market performance. These policies often come with both an earnings cap and an earnings floor, so that, for example, the policy might earn no more than 10%, but no less than 2%, meaning that the policy can continue to grow even in an economic downturn.
This allows clients to continue to participate in the markets with a portion of their retirement assets, because the risk of loss is limited by the policy’s earnings floor. While gain is similarly limited, the risk that a retired client will be forced to hold investments in order to wait for a market recovery (which could impair his or her cash flow for a period) is mitigated.
Eventually, the policy can provide a source of tax-free retirement income for the client. Once the cash value has built up to a substantial level–over a period of years—the client can begin taking tax-free withdrawals to fund retirement, regardless of whether he or she has reached the age at which penalty-free withdrawals from a traditional retirement account become permissible.
If the client’s income level for a given year is higher than expected, IUL can provide a source of tax-free income while allowing assets in traditional accounts to continue to grow.
What to Watch With IUL
In order to realize the benefits of an IUL product as a retirement income source, the client must have the ability to maintain the policy over a relatively long term—generally, at least ten years.The cash value of the policy will grow as premiums are paid in, but it takes several years before the value of the policy will exceed the level of premiums actually paid.
Similarly, many indexed universal life insurance policies contain surrender charge provisions that can last for ten years or more and can reduce the built–up cash value of the policy if the client becomes unable to pay the premiums. Mortality charges that are based on the client’s age and health may also apply, and must be deducted from the contract’s value over time.
As a result, indexed universal life is most suitable for relatively young clients who have at least 10 years until retirement. This ensures that the client has the necessary funds to continue paying premiums on the policy and that the policy cash value will have accumulated to a sufficient level to add value to the client’s traditional retirement income sources.
For the right client, IUL can provide a powerful alternative source of tax-free retirement income—but it can also allow clients who wish to continue investing in the equity markets to satisfy their desire for market participation while mitigating the associated risks.
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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