Life Insurance From An Ira: A Smart Financial Move?

It is possible to convert an IRA to life insurance, but it is not a simple process. An IRA to life insurance conversion involves withdrawing funds from an Individual Retirement Account and using the net amount to purchase a permanent life insurance policy. This strategy can offer tax benefits, but it is important to understand the potential tax implications and consult a financial advisor before proceeding. There are also specific types of life insurance policies, such as indexed universal life insurance, that may be better suited for this strategy than others. Additionally, it is important to consider other factors, such as future tax rates and the availability of other income-generating assets, when determining if an IRA to life insurance conversion is the right choice for your financial goals and objectives.

IRA to life insurance conversion: pros and cons

An IRA to life insurance conversion is a process where an individual withdraws funds from their Individual Retirement Account (IRA) and uses the net amount to purchase a permanent life insurance policy. This policy builds cash value over time, which can be accessed tax-free. It is important to note that this strategy may not be suitable for everyone, and there are potential tax implications and pitfalls to consider.

Pros of IRA to Life Insurance Conversion

• Tax-deferred growth: The cash value of the life insurance policy grows tax-deferred, which can result in exponential growth over time.
• Tax-free access to cash: Policyholders can access the cash value of the life insurance policy through loans, which are generally not considered taxable income.
• Lifetime death benefit coverage: Permanent life insurance provides lifetime coverage, even as the insured ages or faces serious health issues, as long as premiums are paid.
• Penalty-free access to death benefit: Policyholders can access the death benefit penalty-free if diagnosed with a critical, terminal, or chronic illness.
• Long-term care services: The cash value of the life insurance policy can be used to pay for long-term care services.
• Control over inheritance: Life insurance policies offer more control over how beneficiaries use death benefit funds, and the funds are received tax-free.
• No minimum distribution in retirement: Unlike IRAs, there is no required minimum annual distribution in retirement for permanent life insurance policies.

Cons of IRA to Life Insurance Conversion

• Tax implications: Withdrawing funds from an IRA to purchase life insurance is not a qualified "roll-over" or tax-free exchange, so individuals may be subject to income tax and early withdrawal penalties.
• Large tax bill: In the short term, individuals may be responsible for a large tax bill on the withdrawn amount and regular premiums for the life insurance policy.
• Over-funding risks: Over-funding the life insurance policy may trigger a Modified Endowment Contract (MEC), resulting in additional taxes and early withdrawal penalties.
• Investment risks: There are investment risks associated with mutual fund assets.
• Lower death benefit: Taking a loan against the life insurance policy may lower the death benefit.
• Waiting period for gains: Indexed policies may require a longer waiting period to realize gains.
• Not suitable for everyone: Life insurance policies require the individual to be insurable, and the conversion may not be a good fit for all investors.
• Potential loss of benefits: Converting from an IRA to life insurance means giving up certain benefits associated with the IRA, such as tax-deductible contributions and tax-deferred growth.

Can you transfer your IRA to your children?

While you cannot transfer your IRA to a life insurance policy, you can give money from your IRA to fund another person's IRA. However, this is subject to the normal contribution rules and limits. For example, the maximum contribution is $6500 for 2023, the person must have income from working, and their IRA contributions may not be deductible depending on their other income and tax situation. If you withdraw money from your IRA to fund another person's, you must pay tax on it and possibly a penalty. This is because the transfer is not a qualified "roll-over" or tax-free exchange.

If you are giving money from your IRA to fund another person's, you will need to take a taxable distribution from your IRA to obtain the cash, and then the other person will make an IRA contribution, which you deposit on their behalf. The other person must report and enter the IRA contribution into their taxes as if they had deposited the contribution themselves.

You can also open a Roth IRA for your children. A custodial Roth IRA for kids can be opened and receive contributions for a minor with earned income for the year. Eligible income can include formal employment income or self-employment income. The current maximum annual contribution is $7000, or the total of a child's earned income for the year, whichever is less.

If you are considering cashing out your IRA to buy a permanent life insurance policy, it is important to analyse the potential tax implications and consult a qualified advisor to prepare for the long-term investment.

What are the tax implications of converting your IRA to life insurance?

Converting your IRA to life insurance can have several tax implications, depending on the type of IRA and life insurance policy involved. Here are some key points to consider:

• Income Tax on Withdrawal: If you withdraw funds from a traditional IRA to purchase a life insurance policy, you will likely have to pay income tax on that withdrawal. The amount of tax will depend on your tax bracket, age, and the value of your IRA.
• Early Withdrawal Penalty: If you are under 59 ½ years old and withdraw funds from a traditional IRA or Roth IRA, you may face a 10% early withdrawal penalty in addition to income tax.
• Modified Endowment Contract (MEC): If your life insurance policy accumulates cash value above the policy's death benefit, it may be deemed a MEC by the IRS. This could result in taxes on any loans or withdrawals, and you would be subject to early withdrawal rules.
• Tax-Free Exchange: Converting a Roth IRA to a life insurance policy generally presents less upfront tax liability than cashing out pre-tax investments. With a Roth IRA, you can withdraw your contributions at any time without taxes or penalties, but investment earnings may be subject to income tax and a 10% penalty if withdrawn early.
• Tax-Free Death Benefit: Life insurance policies offer a tax-free death benefit, which means your beneficiaries will receive the full payout without paying taxes.
• Tax-Free Loans: You can access the cash value of your life insurance policy through loans, which are generally tax-free. However, any unpaid loan balance at the time of your death will be deducted from the death benefit.
• Tax-Deferred Growth: The cash value of a permanent life insurance policy grows tax-deferred. This allows your investments to compound without the drag of annual taxes.
• Wealthier Individuals: Converting an IRA to life insurance may be more advantageous for wealthier individuals who can benefit from the estate planning and tax-avoidance strategies that life insurance offers.
• Tax Rates: Consider future tax rate increases when evaluating the conversion. Converting at a lower tax rate now may save you money compared to higher rates in the future.
• Fees and Costs: Life insurance policies often come with significant fees and costs, including initial fees, investment fees, and surrender charges. These can eat into your returns and may outweigh the potential tax benefits for some investors.

In summary, converting your IRA to life insurance can have complex tax implications, and it may not be suitable for everyone. It is essential to consult with a qualified financial advisor or tax professional to understand the specific tax consequences of such a conversion and determine if it aligns with your financial goals and objectives.

Can you use your IRA to buy term life insurance?

The short answer is no. IRA accounts cannot hold life insurance investments. However, you can repurpose all or some Traditional IRA funds to pay for a life insurance policy. This is not a qualified "roll-over" or tax-free exchange, so you will be required to pay income tax on the withdrawal.

IRA vs. Life Insurance

When saving for retirement, a 401(k) plan is a great place to start, especially if your employer matches your contribution. But where do you go once you’ve contributed the maximum amount for the match, or if your place of employment doesn’t offer a qualified plan retirement plan? Many workers continue to fund their workplace plan, but there are other options, including using a life insurance policy.

Permanent Life Insurance

In addition to offering a death benefit for your survivors, permanent life insurance policies also feature a savings component. Part of your premium goes toward your death benefit, and another portion builds up your cash-value account, which grows on a tax-deferred basis.

Whole Life Insurance

With a whole life insurance policy, the carrier credits your account by a certain percentage based on how its own investments perform. If you’ve had your policy for a few years, you’ll typically see annual returns in the 3% to 6% range, often earned in tax-free investments.

Variable Life Insurance

Other types of permanent life insurance work a little differently. For example, with a variable universal life insurance (VUL) policy, the amount of the credit is tied to the performance of stock and bond funds of your choosing. The potential returns are higher, but so is the risk. If the market loses ground over a given period, you may have to pay a higher premium to keep your coverage in place.

Term Life Insurance

Term life insurance is a guaranteed life benefit paid to the insured's beneficiaries after death. Policies last for a specified term, usually 10, 15, 20 years or more.

Does it ever make sense, then, to use life insurance as an investment? The answer is "absolutely—in some limited cases." For example, wealthier individuals will sometimes set up what's known as an irrevocable life insurance trust so their heirs can avoid estate taxes. Technically, the trust is paying the premiums for the life insurance policy, so the death benefit isn't considered part of the deceased family member's estate.

What are the alternatives to converting your IRA to life insurance?

Alternatives to Converting Your IRA to Life Insurance

There are several alternatives to converting your IRA to life insurance. Here are some options to consider:

• Roth IRA Conversion: This involves converting a traditional IRA to a Roth IRA. While you will have to pay taxes on the funds you convert, Roth IRAs offer tax-free growth and tax-free withdrawals in retirement. There are also no required minimum distributions (RMDs) with a Roth IRA, which means you can let your investments grow for as long as you want.
• Traditional IRA to Permanent Life Insurance Conversion: This option provides similar benefits to a Roth conversion but with some key differences. With a permanent life insurance policy, you can access the cash value of the policy at any time, and distributions are taxed the same as a Roth IRA without the 5-year wait. Additionally, many permanent life insurance policies offer long-term care coverage, which can be useful for retirement planning. However, it's important to note that converting a traditional IRA to life insurance is a taxable transaction, and you will need to pay income tax on the withdrawal.
• Indexed Universal Life (IUL) Insurance: IUL policies offer tax-deferred growth of funds, tax-free access to cash via policy loans, and the ability to generate market-linked returns. They also provide protection for your principal and previous gains, regardless of the stock market or economic environment. IUL policies can be funded with personal savings or by converting funds from a traditional IRA or 401(k) account.
• Guaranteed Universal Life Insurance (GUL): GUL policies offer stable, long-term death benefit protection with fixed premiums and minimal cash value accumulation. They are a cost-effective option for those seeking permanent coverage without the complexity or higher costs of other permanent life policies.
• Variable Universal Life Insurance (VUL): VUL policies combine lifelong death benefit coverage with flexible premiums and cash value build-up. They allow you to invest and grow your funds through sub-accounts that operate like mutual funds, offering the potential for high returns but also the risk of significant losses.
• Retirement Planning Strategies: Before making any decisions, it's important to consult with a financial specialist or retirement income planning specialist. They can help you evaluate your short- and long-term financial goals, risk tolerance, and available income-generating assets to determine the best strategy for your specific situation.

Frequently asked questions