‘Life Insurance Retirement Plans’ – LIRPs – Offer Tax-Free Savings
Long-term Approach is Essential
For retirement savers who have maxed out contributions to other qualified retirement vehicles such as 401(k) plans and IRAs, a life insurance retirement plan offers a strategy for further building tax-free wealth to be tapped in retirement.
However, this strategy requires taking a long- term approach as terminating the plan prior to death can result in a hefty tax bill.
Moreover, since the life insurance strategy is appropriate only for savers who have maxed out their contributions to 401(k) plans, IRAs and other qualified plans, but who still have a large amount of cash left annually to save toward retirement, it is generally utilized only by individuals with high net worth.
The “life insurance retirement plan” – or LIRP – is a widely used strategy, but a bit of a misnomer. The life insurance policy that is purchased is, indeed, life insurance. It is not a qualified retirement plan. But the intent to use it for retirement savings gives rise to the commonly known LIRP acronym.
How a LIRP Works
The key factor making LIRPs an attractive retirement savings strategy is that life insurance policies are tax-sheltered vehicles as long as they meet certain criteria. Specifically, the taxpayer must make sure the amount of the death benefit based off the cash value of the policy isn’t set at a level that makes it a modified endowment contract, which would make the policy taxable.
To establish a LIRP:
- You purchase a permanent (not term) life insurance policy such as whole life or a variable universal life policy.
- You overfund the premium by paying extra cash into the policy, which is put into a subaccount and invested in mutual funds or a whole life product.
- Over the years, you continue to overfund the policy, enabling the investment growth and capital gains to remain inside the policy.
- Upon retirement, you take a loan against the policy every year to help fund retirement. When you die, the face value of the policy is tax free, so it pays off the loans you have taken over the years.
Now is the Time
With the market down considerably due to the current economic volatility, now is a good time to consider investing in a LIRP if you have excess cash on the sidelines.
Many retirement savings vehicles are taxed when distributions are taken. To avoid diminishing returns due to income taxation investors often look for tax-free solutions. Life insurance policy death benefits are not taxed. Neither are life insurance loans as long as the loans are paid back with the death benefit. So, dollar for dollar, you may borrow as much money out of the policy in the form of a loan as needed, with no tax liability. This can fuel your efforts to get to the “0% tax bracket” that is so valuable to any retirement plan.
The amount you fund into a LIRP can vary widely, depending on your financial and health circumstances that ultimately determine your premium. The premium could range from $1,000 a year to $100,000 a year or more depending on your retirement goals. For example, an investor with an insurable risk of $5 million could justify putting in thousands of dollars a year in excess payments.
Who Should Consider a LIRP?
A LIRP is a reasonable option for someone who:
- Has maxed out contributions to traditional pre-tax retirement vehicles and still has extra cash earmarked for retirement.
- Is healthy. The LIRP strategy is a long game, and you have to be able to qualify for life insurance. If you don’t get the best ratings the premium costs will reduce your rate of return.
- Has the ability and patience to see the policy through until death. Terminating the policy prior to death can cause the loans to become taxable all at once. Generally, people in the 45 to 60 age group are in the sweet spot for considering the LIRP strategy.
The LIRP option is not right for someone who:
- Has inconsistent income.
- Has a short-term saving and investment outlook.
- Isn’t fully funding existing pre-tax retirement plans.
- Has low income or net worth.
If you would like to discuss how a LIRP or other nontraditional retirement saving vehicle may fit into your long-range plans, contact your Adams Brown wealth consultant.