L-I-R-P: Life Insurance Retirement Plan
Put simply, a LIRP is a permanent life insurance policy that builds cash-value.
- A LIRP can provide similar tax-advantages to that of a ROTH IRA, without the income and contribution limitations.
- A LIRP is “powered” by either a whole life policy or universal life policy, both of which allow you to overfund and grow cash-value.
- Indexed Universal Life has become the policy of choice among many investors due to the flexibility and growth potential associated with these plans.
- By overfunding a whole life or indexed universal life policy, policy owners can build a significant amount of cash-value that can be accessed to provide large, tax-free streams of income during retirement.
- In addition to cash-value, a LIRP also provides a death benefit. It is Life Insurance, after all, and the death benefit is the key to accessing all of the amazing tax-advantages within a LIRP.
If you are looking for a powerful retirement vehicle that combines protection, aggressive growth, and tax mitigation, then a LIRP might just be the answer. Let’s take a look under the hood and see if a LIRP is right for you.
What is a LIRP and How Does It Work?
Most of you are familiar with retirement savings plans such as a 401(k)s or IRAs. A 401(k) is typically available through your employer and sometimes comes with a matching benefit where your employer will chip in a certain percentage of your contribution each year. An IRA is an Individual Retirement Plan that allows you to make pre-tax contributions to a market-based investment up to a certain amount each year.
401(k)s and IRAs are known as Qualified Plans that allow you to receive a tax deduction for the current year. However, when you begin taking distributions (withdrawals) in retirement, you will be taxed at the current income tax rates.
These qualified plans are also capped at a maximum annual contribution.
A LIRP works much differently. It is a Life Insurance Policy that allows you to accumulate cash-value inside the policy throughout your working years so that you can take tax-free distributions in retirement.
Because your retirement distributions are tax free, they do not increase the taxation of your Social Security Benefits, like a qualified plan (IRA, 401k).
While Life Insurance Retirement Plans may seem like a relatively new concept, this strategy has been used successfully for decades. Borrowing on the concept of shoring up our nation’s retirement system, LIRPs have become an increasingly popular alternative to the 401k and IRA.
In addition, with the decline of defined benefit plans and pensions, LIRPs have emerged as a flexible and tax-efficient vehicle for providing lifestyle-sustaining income in retirement.
Let’s go over some of the benefits found in a Life Insurance Retirement Plan: (you can also use the links below to jump to each section)
- Tax-Free Growth, Tax-Free Income
- No Income Threshold Limitations
- No Maximum Contribution Limits
- Many Indexing Options Available
- Available Cash-Value May Be Accessed Through Policy Loans
- Permanent Death Benefit For The Life Of The Policy
- Life Insurance Is Not Free
- Flexibility To Change Features As Your Life Changes
- Powerful Annual Reset Feature
- Market Loss Protection Through Indexing
Tax-Free Growth, Tax-Free Income
One of only two things that are certain in this world (Death and Taxes), Taxes play a very important role in our investment and retirement saving decisions. If you haven’t given any thought to how much of your retirement will be subject to taxation, now is the time to start.
Recall that a 401k and IRA are known as qualified plans which means that the IRS is keeping track of these plans throughout their lifespan so they know how much tax you still owe. Because they are tax-deferred, you only pay taxes when you begin taking withdrawals in retirement.
The question is, what will the tax rates be during your retirement?
The truth is, nobody knows. And the reality is, they’re very likely to be much higher than they are today. All we need to do is take a look at the National Debt Clock (usdebtclock.org) to see how fast this nation is spending money. How do we begin to pay this back? We also must consider how we are going to continue to fund all of the government programs in the future.
The threat of higher future taxation is a serious concern for folks saving for their retirement.
Many people surmise that they will pay less in taxes when they retire because they won’t be making as much income. This might be true, however, typically, retirees also aren’t eligible for as many deductions that help reduce their tax liability. We call this the Deduction Reduction and it can have a major impact on how much of your income is subject to taxes.
Most people who have worked in their life will be eligible for Social Security when they reach a certain age. But the IRS has a trick up their sleeve for Social Security recipients as well.
If you are a Single Filer, the first $25,000 of your retirement income (social security or other income) is tax free. However, if you pull in $25,000 to $34,000 in combined income, you will be required to pay taxes on up to 50% of Social Security benefits. If you make more than $34,000, 85% of your Social Security may be taxed as ordinary income.
If you are married and filing jointly, the numbers are only slightly better. For the first $32,000 of income, you pay no taxes. Make between $32,000 and $44,000, and you’ll pay ordinary income tax on up to 50% of Social Security benefits. Above $44,000, up to 85% of benefits may be taxed.
Combined income is the key phrase here. For tax purposes, combined income means half of your household Social Security income plus income from all sources that are subject to taxation.
Let’s say you and your spouse are both receiving Social Security Benefits. As of January 2020, the average Social Security payment was $1,503.00 per month. This works out to about $18,000 per year for each of you for a total of $36,000. So, take half of that Social Security income ($18,000) and add any income you may be receiving from your 401k or IRA. If the combined total is greater than $44,000, you will be required to pay taxes on 85% of your Social Security benefits.
The IRS treats a LIRP much differently than these qualified plans. Because you make contributions to your policy with after-tax money, your cash-value is never subject to future taxation.
This rule also applies to how your Social Security benefits are taxed in retirement. Since your distributions from a LIRP are in the form of policy loans, they don’t count toward your combined income for tax purposes. In other words, LIRP withdrawals don’t increase your taxable income and have no effect on how much tax you owe on your Social Security benefits.
Recall that the IRS looks at combined household income to determine how much of your Social Security benefits are taxable. In the case of our previous example, only $18,000 of your Social Security would be considered as combined income. Which means your tax liability is far below the $32,000 minimum threshold for married filing jointly and even the $25,000 minimum for single filers. You: 1 IRS: 0.
Would you like to retire in a
No Income Threshold Limitations
To understand income threshold limitations, we need to once again look at an IRA and a Roth IRA. These types of government-controlled plans come with a cap on how much money you can make in order to even make contributions. For a Roth IRA, if you are married filing jointly, you aren’t eligible if your income exceeds $206,000.
If your household income is below that threshold, you are still only able to contribute up to $6,000 per year ($7,000 if you are over the age of 50).
These same contribution limits are found in an IRA.
A LIRP has no such income constraints.
No Maximum Contribution Limits, Sort Of…
We have already discussed the maximum contribution limits of an IRA and Roth IRA. But what about your 401k?
For most 401k participants, your annual contribution is capped at $19,500 for 2020. If you are over the age of 50, you are allowed a “catch-up” contribution each year of up to $6,500.
Often, 401k plans are accompanied by an employer match which help increase your annual contributions are not counted toward your maximum contributions. There are limitations to the amount of money your employer can contribute as well and is typically based on your annual income.
Life Insurance Retirement Plans have their own contribution limits, but they are much higher than qualified plans.
It would be nice if you could just contribute any amount of money you want, but the IRS would certainly take notice if you could.
Since a LIRP is essentially a life insurance policy with a cash-value bucket, the contribution limits are based upon the face value of your death benefit and the amount of the premiums associated with it.
The IRS has placed restrictions on these types of policies so that funding doesn’t exceed tax law limits. In other words, if you contribute too much money to a LIRP, the IRS no longer considers it a life insurance policy and you will lose all of the tax-saving benefits that life insurance provides.
Once your premiums exceed tax law limits, the policy becomes what is known as a Modified Endowment Contract (MEC). Once the policy has been classified as a MEC, it can never be unclassified as a MEC and will never regain its previous tax advantages.
This is important to note, however, very unlikely to occur. The insurance companies that offer these types of policies are very aware of the IRS rules regarding MECs and will refuse to accept premiums that exceed the IRS limits.
That being said, the concept of a Modified Endowment Contract is what determines the maximum contribution limits to your policy.
Each policy is issued with its own MEC premium limit that is based on several factors including the age of the policy owner and the face amount of the death benefit. This amount must pass the 7-pay test in order to prevent the policy from being considered a MEC.
The 7-pay test basically states that if you contribute enough premium to the policy to pay it in full in 7 years, then the policy is considered a MEC.
Since the premium limit is tied to the face amount of the policy, essentially you have control over how much you want to contribute simply by increasing or decreasing your death benefit.
Many Indexing Options Available
Now that we’ve discussed some of the tax advantages of a LIRP, let’s dig a little deeper into the growth side of this strategy.
Many insurance companies will offer a variety of indexing options so you can decide how you want to allocate and grow your money.
Let’s start with one we’ve probably all heard of – the S&P 500. Aptly named because it is an index of 500 large-cap U.S. companies. Companies like Microsoft, Apple, Alphabet, and Facebook are included in this index. Some of these companies have made investors millions and millions of dollars many times over.
These high-performing companies sell shares at a premium. For example, as of this writing, Alphabet (Google’s parent company) shares are worth $1,417 per share and Amazon is selling at $3,123.92! For many investors, purchasing one share of each of the 500 companies in the S&P is simply not practical.
Indexing offers LIRP owners a way to participate in the upside of an index (such as the S&P 500) while protecting them from market downturns. To put it another way, if the market does really well, your policy does really well. If the market crashes, you simply get a 0% return for that period.
The growth of your policy is determined by the accumulated cash-value as well as the performance of the index that your policy is tied to. We’ve already mentioned the S&P 500, but there are literally hundreds of indices that you can choose to allocate within your policy.
And since some indices perform better than others in certain years, you have the flexibility to re-allocate your funds as you see fit.
But re-allocation is only one of the benefits of indexing.
Take a look at the chart below. It details the performance of $100,000 invested in three different investment vehicles beginning in 2007. The Red Line represents the actual historic data of the S&P 500. The Blue Line represents a fixed indexed annuity at a 2% growth of compounding interest. The Green Line represents an Indexed Universal Life policy that tracks market performance, but is protected from market loss through 0% crediting during down turns.
If you look closely, you will see that during the crash of 2008, the S&P 500 lost nearly 40% while the LIRP strategy retained its value. This zero-risk strategy is what allows you to preserve your investment’s growth while participating in the upside of market recovery. More on this later.
Available Cash-Value May Be Accessed Through Policy Loans
One of the most valuable features of a LIRP is the option to access your accumulated cash-value at any time, for reason, without penalty, through policy loans.
This is basically a loan from the insurance company that has issued your policy. There is no credit check or application to fill out. The insurance company has the cash-value of your policy as collateral, so they have no risk in loaning you the money.
These loans can be used to buy a car, pay for college tuition, start a new business, remodel your home – anything you like.
You don’t have a repayment schedule or repayment date, in fact, you don’t have to pay back the loan at all. However, if you don’t repay the loan, the interest and the principle will reduce the face amount of your death benefit.
It is important to note that different insurance companies have their own rules regarding policy loans. It is important to discuss these with your insurance agent before purchasing a policy or taking out a policy loan.
When used responsibly, policy loans can reduce the amount of money you pay someone else for interest. When you borrow money from a bank, you pay them interest as the cost of using their money to make a purchase. For large purchases, like a home or a car, the cost of interest can add up.
Many College Planning experts are also taking advantage of the flexibility of LIRPs to help families cover college tuition expenses.
It’s your money after all, shouldn’t you be able to use it whenever you want, however you see fit?
Permanent Death Benefit For The Life Of The Policy
As we’ve discussed, in order for the IRS to look the other way while you enjoy all the tax advantages of your LIRP, there must be a death benefit tied to the policy.
The death benefit tied to a LIRP is a whole life or universal life policy which is different than a term policy. Where a term policy expires after a specified period of time (usually 10 or 20 years), a permanent life policy is, well, permanent.
Life Insurance Is Not Free
Instead of making bets that you won’t die within the next 10-20 years, as with term life, a permanent policy is guaranteed to pay out your death benefit when (not “if”) you die. Should your policy remain in force, you will die at some point and the insurance company will have to pay your beneficiaries a large sum of money. This is key to understanding the difference in costs of a term life policy and a permanent policy.
The reality is that most people that own term life policies rarely keep them until their death. The premiums of a term policy are structured so that while you are young and healthy with a long life-expectancy, they are very affordable. As you age, and your life-expectancy begins to decrease, the cost of these policies begins to rise, dramatically.
The reason for this is that the insurance actuaries (the number crunchers) have figured out the likelihood of you dying within a certain period of time based on your age. Like any statistic, they can apply these numbers to their entire population of customers. This way, the insurance company can determine the rate of premium to charge that will still net them the most profit, after taking into account the small percentage of policy holders that will actually die.
This is not an indictment of term life insurance. Just take a look at all of the deaths from COVID-19 over the past year and you’ll see just how unexpected death can be. Had those individuals been covered with a term policy, their families would at least have had some financial security after their loss.
However, when we’re taking the long road and glimpsing into our retirement future, we need to be sure we have all of our bases covered. Term life insurance quickly becomes an unaffordable option to provide a death benefit.
Taking out a permanent policy when we are young and healthy, helps to spread the cost of the death benefit over many years. Due to the fact that this type of life insurance is permanent, the insurance company will have to pay out at some point. For this reason, when compared to term life policies, permanent life insurance premiums tend to be higher. How much more? That depends on the amount of coverage. If you want to know exactly what costs are associated with a LIRP, I recommend you speak to an insurance agent who specializes in properly structuring a life insurance retirement plan.
The most important investment you can make is in ~Warren Buffet
Flexibility To Change Features As Your Life Changes
When we begin talking about the flexibility found in a LIRP, we need to understand a few things. First, financial goals change throughout our lifetime. Second, the future is always uncertain. And, thirdly, retirement isn’t the end of our story, it’s simply another chapter.
It’s fairly easy to understand how financial goals can change throughout our lifetime. When we’re young and just beginning our careers, our goal may be to make enough money to buy our first home, start a family, a business, or simply pay off our student loans. As we move through the stages of life, we encounter new challenges. Some expected and some unexpected. For many, having children changes the game entirely. That money we were saving towards a new bass boat might need to be reallocated to pay for diapers and baby formula.
The point is, plans change. Locking yourself into a financial plan that doesn’t grow with you is like trying to fit into the same tuxedo you wore to prom 30 years ago. There is simply no way to account for all that life will throw at you as you grow older, so we also need to remain flexible.
An uncertain future is perhaps what inspires us to start saving in the first place. Just take a look at the past year. Did you see it coming? Now go back a little farther. The past 10 years. A lot has happened in the past decade. 20 years? Too much to cover here. What about 45 years? That’s the number of good working years that most of us have in us. That takes us all the way back to 1975. The world and our lives looked much different back then. Life is uncertain which keeps it interesting, in my opinion.
A Life Insurance Retirement Plan offers you the flexibility to make changes to how much you are contributing towards retirement, the face amount of the policy, what indexes you are invested in, even how much income you are taking during a given year in retirement. You don’t need anyone’s permission; you are in complete control over how you use your policy.
Annual Reset Feature
This simple but powerful feature is what makes an IUL such an exciting investment vehicle for your retirement.
As we discussed earlier, your LIRP is based on the performance of a particular index that is tied to the market. This means that your policy is not actually in the market. Why is this a good thing? Because if the market has a bad year, your policy will simply be credited 0% instead of losing money.
Compare this to a mutual fund or your typical stock and you’ll find that there is no such protection provided with these types of investments. If the market has a bad year and your mutual fund loses money, so do you.
Let’s look at an example. You have $100,000 invested in your 401k and $100,000 in cash-value in your LIRP. If the market makes a correction (like it did earlier this year) and you lose 20% of your 401k’s value, it’s now worth $80,000. At the end of that same year, your LIRP is still worth $100,000 because of 0% crediting.
As we typically see markets rise sharply after big losses, once that losing year passes, we can expect that we will recover some of what we lost in our 401k. However, our 401k begins tracking its growth from $80,000, while our LIRP begins its growth from $100,000 because we didn’t lose any of our cash-value. With me so far?
Now let’s assume that the market recovered the entire 20% that was lost the previous year. How much is your 401k worth? $96,000. The reason is that 20% of $80,000 is only $16,000, so even if the market recovered 20%, you’re still short $4,000 from where you were just a year ago. Whereas your LIRP was able to participate in the 20% growth and is now worth $120,000.
This is a very simple example of how a LIRP can harness the power of market volatility in positive way. The stock market, by its very nature, is volatile; there’s no avoiding that fact. But it’s this volatility, coupled with market-loss protection, that make a LIRP a very powerful retirement vehicle.
Market Loss Protection Through Indexing
By now you hopefully have a fairly basic understanding of how a LIRP functions and how it can protect your retirement savings from market losses.
However, let’s take it one step further and look at some historical data to illustrate the importance of market loss protection.
Some of you may be familiar with the concept of “time-value of money” that states a given amount of money is worth more today than its future value due to the interest earning “potential” of money.
That earning potential can only be realized when money is used properly. If we make poor investment choices, the concept of money being worth more today than in the future gets flipped on its head.
For example, we may have been better off sticking our money in a mattress than buying stock in 2007 before the market tumbled.
I’m sure I don’t have to remind most of you of the events surrounding the 2008 market crash. It’s likely still fresh on most people’s mind. And if you were in the market at the time, you may even still feel the sting.
Suffice it say, people lost lots of money and what followed can only be described as a financial catastrophe. Government bailouts, housing foreclosures, life savings up in smoke.
Of course, this wasn’t the first time a bubble had burst and the market collapsed. In fact, just 6 years earlier, the Dot Com bubble sent markets reeling.
During this period of time, financial advisors and experts were telling their clients to hang in there because the market will recover. And you know what? They were right. The market did recover.
By 2012, the market had fully recovered back to pre-2002 levels. And by “recovered” I mean “right back where it started”.
Investors had lost an entire decade of growth on their money. We call this the “Lost Decade”.
It’s one thing to lose money in a market downturn, it’s an entirely different thing to wait patiently for the market to recover over a 10-year period. What if you didn’t have 10 years to wait? What if you retired in 2001 and began taking distributions from your 401k only to see it lose 40% overnight? What does that do to your retirement plans?
Any good financial advisor will tell you that when you reach a certain age, you need to begin thinking about transitioning from “growth” to “preservation”. Growth is what we strive for in our working years. Preservation becomes a necessity in our retirement years. We need to protect what we’ve worked hard for.
But as we’ve just illustrated, a LIRP can provide growth as well as preservation throughout our entire lives.
LIRP owners from market volatility
Imagine instead of having your retirement savings in the market during 2008, you owned a LIRP. During the crash, your policy was protected, and when the market began its record-setting ascent in 2009-2012, you were able to participate in all of that growth. Wouldn’t you want to at least know about something like that?
Some Closing Thoughts Life Insurance Retirement Plans
- The more time you have, the better your LIRP will perform. This means that starting sooner can help you build larger cash-value which translates into more income in retirement.
- Remember, a LIRP is first and foremost a Life Insurance policy. There will be some amount of death benefit tied to your retirement plan. This is key to maintaining the tax-advantages that come with a LIRP.
- As a life insurance policy, there is a cost associated with your death benefit. Typically, the premium is based on the face amount of the policy as well as your age and health conditions. Don’t go overboard with your death benefit. Work with your agent to determine a reasonable amount of coverage that will still enable you to achieve your income goals in retirement.
- Prevent your LIRP from becoming a Modified Endowment Contract (MEC) by enlisting the help of an experienced agent that knows how to properly structure your policy. Once a MEC, always a MEC.
- A LIRP is a long-term commitment. Yes, you can build an enormous amount of cash-value within your policy, but it takes time. Get started early so you can take advantage of the power of market protection and compounding interest. After all, the best time to plant a tree is 20 years ago, the second-best time is today!
- A LIRP doesn’t have to be your exclusive investment vehicle. Depending on what stage of life you’re in, you might have a risk-tolerance that allows you to take some chances in the market. I say go for it. A LIRP is designed to be your foundation and as long as your foundation is strong, your financial house will always stand.
- Are you the set-it-and-forget-it type that would rather put your retirement plan on autopilot, or are you the active investor that likes to follow the market and make strategic moves to maximize your returns? A LIRP provides you the option to do both. By re-allocating your funds as you see fit, you can maximize your returns. Or, you can simply choose your favorite index and watch your cash-value grow at a steady rate.
- Not all carriers are created equal. Again, discuss your carrier options with an experienced insurance agent that has a proven track record of protecting their clients’ money and retirement future. Many new agents are unable to obtain contracts with the best insurance carriers due to production requirements. Agents that have experience often have a number of different carriers they work with and will know which carriers will offer the LIRP plans that will benefit you the most.
- When evaluating the pros and cons of different retirement vehicles, be sure you look at the whole picture. Consider things like taxation, management fees, exposure to risk, liquidity, and income. Remember, wealthy people aren’t great investors, they’re great savers and use money as a tool, not a goal.
- We’ve got a lot to look forward to after we stop working. Most of us will be grandparents by then, some of us many times over. We have hobbies, interests, travel, friendships, and relationships to cultivate. And let’s not forget all of the good causes we could donate our time to. A LIRP can provide you with lifetime income so you can maintain a good standard of living.
- Get creative in your planning goals! A LIRP is a powerful tool that has the potential for a multi-generational transfer of wealth. A tax-free death benefit to your beneficiaries can enable them to fund their own retirement and establish their own death benefit that can then be passed on to their beneficiaries. Discuss these strategies with your entire family so they know how they too can implement it in their own plans.
But above all, be sure you’re hiring an expert to setup your LIRP. You want to be absolutely sure that your life insurance retirement plan is setup properly to prevent any surprises down the road.
Well, we’ve covered a lot of ground in this article. I hope you found it informative and have a better understanding of the potential benefits of a Life Insurance Retirement Plan.
This is not a one-size-fits-all solution, however, as everyone’s situation is different. We know LIRPs and have been helping our clients secure their financial future with safe investment strategies for over 20 years. If you would like a confidential personalized proposal to help you decide if a LIRP is right for you, please call Focus Financial Group at (417) 518-3871 or toll-free at (888) 208-9710 during normal business hours or contact us through our website www.focusfg.net anytime.