Life insurance as income tool

Among today’s retirement income strategies, what’s old is new again.

It wasn’t too long ago that cash-value life insurance — policies that provide a death benefit and a pot of cash that grows tax-deferred, such as whole and universal life — were marketed for their potential to provide income tax-free. Now, amid today’s stringent income tax environment, cash-value policies have become so popular that clients are asking advisers about them.

“The bottom line is that the policy allows you to tax shelter, and because of that, you’re able to have substantial deferral in your high-income years,” said Robert S. Keebler, a partner at Keebler & Associates LLP. “This is about smoothing out your income.”

In the scheme of tax-efficient withdrawals, the cash-value life insurance policy is in the same category as the Roth individual retirement account: tax-free income. While cash values grow on a tax-deferred basis, policyholders can tap that pot of money on a tax-free basis. However, withdrawals reduce the death benefit.

At this point, clients are jumping to talk to advisers about how to structure life insurance for retirement income. “Advisers are being contacted by clients proactively this time,” said Adam Hyser, director of life insurance marketing at ValMark Securities Inc. “There’s an uptick in interest.”

Whole life insurance comes with a cash value that grows from interest credited to the account. Premiums generally are fixed. Participating whole life, available at mutual insurers, credits company dividends to the cash value from the carrier’s own excess profits.

Universal life insurance offers a cash value that also grows based on interest credited to the account. Unlike whole life, however, the premiums are flexible, meaning clients can fund it by a minimum amount if they wish and use the cash value to fund the policy costs. Policy owners can also raise or lower death benefits.

There is also an investment component to UL: Carriers offer indexed UL, which credits interest based on movement in an index, and there’s also variable UL, which invests in the stock market.

Advisers recommend that clients give the policy 10 to 15 years to grow before they consider using it as a supplement for retirement income. They disagree with buying life insurance solely for the cash-value benefit and instead view the supplemental income as a way to use a policy that already exists.

RE-PURPOSING A POLICY

“Say that I buy the insurance policy when I’m in my 30s because I have two young children, but now my son is approaching 40. Do I really need the insurance?” asked Jim Swink, vice president of Raymond James Insurance Group. “Probably not, but it has cash value, so maybe I can re-evaluate the purpose and use it to supplement retirement income.”

Advisers position it as a fixed-income alternative in a client’s overall portfolio, particularly if the policy is paying dividends toward the cash value. “With whole life, you can withdraw your basis and not pay a dime in taxes,” said Greg Olsen, an adviser with Lenox Advisors LLC.

With universal life and flexible premiums, advisers note that clients need to maximize their payments so most of the money is going toward the cash value.

“You certainly shouldn’t expect to take a lot of income out of a policy that you fund only minimally,” Mr. Hyser said. “This should be viewed as something you’re planning to fund pretty well if cash value is the purpose.”

The strategy of re-purposing life insurance for cash value isn’t foolproof. Policy illustrations, particularly for universal life insurance, shouldn’t be so optimistic that they assume favorable markets, making it appear to the client that he or she won’t have to contribute as much money to the policy. Buyers of variable universal life were stung in 2008 when the policy illustrations failed to consider the steep market downturn, leading to rapidly plummeting cash values and outsize premiums to keep the policy from imploding.

TOO OPTIMISTIC

“If it [sounds] too good to be true, it probably is,” Mr. Hyser said of optimistic universal-life illustrations. Advisers should model different rates of return, he added.

The internal rate of return on a cash-value life policy is appealing if the client holds on to the policy until death — meaning the beneficiaries are landing a massive windfall, noted Michael Kitces, a partner and director of research at Pinnacle Advisory Group Inc. 

That certainly doesn’t mean clients should raid their policies for income in retirement, as clients can wind up having to pay taxes on all previous withdrawals if policies lapse, he warned.

“I’m negative on using it for income,” Mr. Kitces said. “You need to make sure you never have the policy run out of money, because if it does, you lapse the policy and get a giant tax bill. It’s better to hold the policy and use the death benefit.”