Beyond the Roth IRA: Life Insurance for Tax-Free Retirement Income

Thanks to medical advances, Americans can easily live more than 20 years in retirement, which means they’ll likely need a lot of money during their retirement years. But your clients should be worried about more than just the risk of outliving retirement savings; a myriad of taxes even in retirement can eat away at a person or couple’s assets. That’s not to mention unexpected medical costs should a chronic or terminal illness arise: According to the U.S. Department of Health and Human Services, one year in a long-term care facility can cost anywhere from $32,032 to $56,056, depending on geography.

Taxable retirement benefits cut into savings

For retirees, even affluent ones, cash flow is an absolute necessity in retirement. What many people don’t realize, though, is how quickly taxes can eat away at any income stream. Take Social Security benefits, for starters. More than 60 percent of Americans 65 years old or older receive 50 percent of their retirement income from Social Security—and most retirees don’t have to pay federal income taxes on the benefits. But for retirees with substantial income, in addition to Social Security, they can be on the hook for taxes on up to 85 percent of their Social Security benefits. The Social Security Administration said in December 2015 that around one-third of those collecting Social Security pay federal taxes on their benefits.

But the potential tax hit doesn’t stop with Social Security.

• Retirement account withdrawals: Once retirees begin withdrawing income from traditional IRAs or 401(k)s, the earnings portion of withdrawals are taxed at the retirees’ regular income tax rates (which are often lower in retirement, compared with their rates while working).
• Roth requirements: Roth IRA withdrawals are not taxable unless retirees meet certain requirements. For a distribution to qualify, a retiree must wait at least five tax years after making his or her first Roth contribution before taking a withdrawal, and the retiree must have reached age 59½, died, became disabled or used the withdrawal for a first-time home purchase.
• Required minimum distributions: When a person reaches the age of 70½, he or she must begin taking required minimum distributions from his or her 401(k) or traditional IRA. The penalties for not doing so are hefty: According to Internal Revenue Code 4974, the amount of money a person should have taken from the account will be taxed at 50 percent.

And, of course, when your clients die, their heirs will owe taxes on any money left in qualified retirement plans.

Life insurance: an often-overlooked retirement income source

For clients who face a hefty tax bill in retirement, a dwindling cash flow need not be a foregone conclusion. There are ways to reduce tax events while generating retirement income, and life insurance is an often-overlooked option for doing so—as long as there is a need for a death benefit. When it comes to life insurance, the most important feature is, and always will be, its ability to provide for and protect loved ones or a business after the policyholder’s death.

But certain types of life insurance products can actually provide both a death benefit and supplemental income with growth potential. Withdrawals from the basis of these life insurance policies (i.e., the amounts already paid into them) are considered tax-free income. Loans are typically tax-free, per IRC section 72(e)(5). Using this income stream first could limit the need for retirees to tap into taxable retirement income in order to cover expenses. What’s more, life insurance never goes unused. Clients buy it, build a cash value, use it for income—or not—and pass on the remainder as a death benefit. The benefit can be tax-free under IRS Tax Code 101. Unpaid loans and withdrawals from a permanent life insurance policy will reduce, or even eliminate, cash values and the death benefit and may have tax consequences.

Life insurance can also help cover any estate taxes due at death, along with increasing the financial legacy left to heirs.