One of the longest standing arguments in the insurance business is buy term and invest the difference or buy cash value life insurance.

The argument of buying term and investing the difference is based on the premise of getting cheap term and taking the extra money (you would have spent on whole life) and investing it in the market.  The thought is that you can make a higher return with the money in the market than you can inside a life insurance contract.

While the true accumulation value of an investment account can be higher than the accumulation value of the cash value, other factors must be considered.   For example, what if your investment account performs poorly and you actually lose money.   A life insurance policy has certain guarantees built into it that guarantees that you will not lose money no matter what.

Also, a big consideration needs to be from a tax standpoint.  What is a modified endowment contract?  Where will you invest?  What is your tax bracket?  What will the tax bracket be when you want to access the money?  Would it help you to have money that you can access tax-free from the life insurance?  Is the death benefit being passed tax-free going to be a benefit to your estate and family.

Term is a great way to cover your liability at a very reasonable price.  The problem with term is that it only lasts for a period and most people outlive the term and their family never sees a benefit.  Often times a combined approach can be a good one.   In other words, having a majority of the coverage as term and part being whole life or universal life.

Permanent life insurance can be a great supplemental retirement tool to tap into.  If you set up the policy the correct way and take advantage of the tax-free benefits, you can see real value.

Many people don’t understand permanent life insurance and that includes many of the agents, CPA’s, Attorney’s, talk show hosts (you know who you are) etc.   If you understand how the tool works, I think you will really see the value.    The way to set up the life insurance policy to use it as a supplemental retirement, starts with the funding.  You should try and fund the policy, just under the MEC level.   MEC stands for Modified Endowment Contract and that is when the cash value loses its tax free status.   In other words, when you hit the MEC level you have gone to far.    The idea is to put as much money in the policy as possible and get the tax advantages available under IRS guidelines.

In order to take advantage of the benefits of  a life policy as a tax free supplemental retirement tool, you must know how to access the money.  You should  start by taking out the money as withdrawals up to your cost basis.  Since it is your contributions to the policy, there is no tax up to the cost basis.  When you reach the cost basis, then you shift to taking preferred policy loans.   If you do it this way, you can avoid paying income taxes on the money.  Whatever money you take out as a withdrawal or as a loan, is simply deducted from the face amount (death benefit) of the policy.  The only difference is you can’t put the withdrawal money back into the policy if you want, but you can on a loan.

There are three buckets of money on people’s financial models and they are taxable, tax deferred, and tax-free.  Obviously, the goal would be to have as much money in the tax-free area as possible.   With tax favorable treatment, the government will put limitations on how much you can put int he tax deferred and tax free buckets.  There is no limitation on the taxable bucket as they want to collect as much current tax as possible.

Most people feel that tax deferred is the greatest thing in the world, but it is not all good.  When something is tax-deferred it means that the tax is deferred to be paid later.  Once the 401k or pension plan compounds for many years, there is also a very large tax bill.  In other words, if you have 1 million dollars your net will be about 30 to 40% less after taxes.  In bucket number 3 which is tax-free, you have limitations in regards to how much you can put in.   The two main tax-free items are permanent life insurance and Roth IRA’s.   Both of them are limited in terms of how much money can be put in on a yearly basis.  With life insurance, each policy has a MEC limit that is the maximum that can be put into the policy and remain tax-free.  If you put money above the MEC limit in the policy then you will be taxed on the gains.  A Roth allows you to put only so much money in per year and then if you earn too much you can’t start one.  If you can learn how to use the cash value of the life insurance through withdrawals up to cost basis and through preferred policy loans, you can avoid paying taxes on the gains.

I recently got a comment from one of our blog entries about not explaining how to tap the cash value tax free.  I wanted to devote this entry to explaining how to use this valuable asset with out paying a penny of tax.  The key to the cash value is to building it by putting  money into it for a period of time.  Once you have built it up a little bit, then you can start pulling it out to buy whatever you want during your lifetime.  You pull it out as a preferred policy loan and all you have to do is bay the interest to the insurance company.  Typically the interest rate is like 6-7%.  The key to growing the cash value over time is to pay back the loan and pay it back above the insurance loan cost.  I like to pay back at about 10% and amortize over 4 or 5 years.  This money just goes back into your account and the spread above the insurance companies interest goes directly into your policy to turbocharge it.

In regards to tapping the money from the permanent life insurance policy for tax-free retirement, you should use this strategy.  Start by withdrawing from the policy up to your cost basis for initial income.  Since it is cost basis it is not taxable.  Once you withdraw the full cost basis, you start taking money out as preferred policy loans.    The policy loans come out of the policy tax-free and the only cost is the interest on the loan.

Life insurance cash value (whole life or universal life) can be a great supplement to your retirement income. To live a healthy financial life it makes sense to diversify and build value in different vehicles. Some of the great benefits of using life insurance to supplement your retirement is that if done correctly you can withdraw the money tax free. Qualified plans are great, but they are fully taxable at retirement as you have never paid tax on them. They also have restrictions about distributions and penalties for early withdrawals. I recommend putting the amount in your qualified plan that gets you the full match. After you hit the match amount, I suggest you may want to put the money above that in a separate vehicle. Compound interest is great, but compound tax is also an issue to consider.

The way to use life insurance to supplement your retirement is to take the money out as a withdrawal up until you hit your cost basis. Withdrawing money to your cost basis, should not be taxable. Once you hit the cost basis, you should start taking the withdrawals as policy loans. If you do it this way you should be able to access the money built up tax-free. The earlier you start the policy the better as a significant amount of money can be accumulated over time. I usually suggest to my clients that they overfund the policy. In other words add cash to the policy each month above and beyond the premium level. On top of the great supplemental income and tax benefits, you should have a nice death benefit to pass along to the next generation.