Life Insurance: A Smart Retirement Strategy?

Life insurance is often viewed as a simple way to replace income or cover final expenses, but it can also be a part of a broader retirement plan. Life insurance retirement plans (LIRPs) are permanent policies that have a cash value portion that accumulates savings over time. This cash value can be used to complement your existing retirement savings or as a source of income in retirement. While life insurance may not be the first thing that comes to mind when planning for retirement, it is worth considering how it can help maintain your lifestyle during your golden years.

Buy term insurance

Life insurance agents often promote permanent life insurance that accumulates cash value as a way to save for the future. However, for retirement planning purposes, such policies usually only make sense for high-net-worth individuals. For almost everyone else, the best way to incorporate life insurance into retirement planning is to buy a simple term life policy with an adequate death benefit.

Who Needs Life Insurance?

Except perhaps for the independently wealthy, anyone who has children or other dependents who rely on their income for support needs life insurance. That's also true for "nonworking" spouses; stay-at-home parents or homemakers, for example.

“For the working spouse, you want to have enough insurance to cover large debts (such as a mortgage), future obligations that can no longer be funded by the earnings of the deceased (such as costs for college or retirement), and living expenses for the family," says Kristi Sullivan, CFP, of Sullivan Financial Planning, in Denver.

"The nonworking spouse needs to be insured to cover the cost of child care and other household-management work that the surviving breadwinner will now have to pay for,” she adds.

How long a term the policyholder needs depends on how many years into the future others are likely to be dependent on them. When their kids are grown up and financially independent, they may no longer need life insurance or as much of it.

The least expensive type of life insurance, considering not just out-of-pocket costs but also the amount of coverage you get for the money, is term life (sometimes called "pure life insurance"). It guarantees payment of a stated death benefit during a specified term—such as 10, 20, or 30 years—but has no cash value component. When the term expires, the policyholder can either renew for another term, convert to permanent coverage, or allow the policy to terminate.

Given these costs, term life insurance can be a useful retirement savings tool in two ways. First, it provides the basic financial protection a family will need if one of the breadwinners dies before accumulating enough savings for the family to live on. Second, the relatively low price frees up more disposable income to use for other purposes.

“Given the lower premiums associated with the policy, investors will have more to invest for retirement, college, or other financial goals," says Mark Hebner, founder and president of Index Fund Advisors in Irvine, California, and author of Index Funds: The 12-Step Recovery Program for Active Investors.

Create an emergency fund

Creating an emergency fund is an essential step in your financial planning journey. An emergency fund is a cash reserve set aside for unplanned expenses or financial emergencies, such as car repairs, home repairs, medical bills, or a loss of income. Here are some detailed and direct instructions to help you create an effective emergency fund:

Determine the amount you need:

The amount of money you should keep in your emergency fund depends on your personal situation. Consider the types of unexpected expenses you may have encountered in the past and how much they cost. Most experts recommend having at least $1,000 in savings, while others suggest saving enough to cover essential expenses for three to six months.

Set clear goals:

Having a specific savings goal will help you stay motivated and on track. Calculate how much you want to save and how long it will take to reach your goal, based on your income and expenses. This will give you a clear target to work towards.

Create a savings plan:

Develop a sustainable budget and savings plan that works for you. Put away a small amount each month, ensuring it's affordable for your financial situation. You don't want to save so much that it creates a financial crisis! Consistency is key, so make regular contributions to see your savings grow over time.

Automate your savings:

Consider setting up automatic recurring transfers from your checking account to your savings account. This way, you save effortlessly without having to remember to transfer funds manually. You can decide on the amount and frequency of these transfers. Just ensure you monitor your balances to avoid overdraft fees.

Keep it separate:

Maintain your emergency fund in a separate account from your everyday spending money. This helps you resist the temptation to spend it on non-emergencies. Keeping your emergency fund in a dedicated bank or credit union account is a safe and accessible option.

Stay disciplined:

It's important to use your emergency fund only for true emergencies. While it's tempting to dip into it for non-essential purchases, remember that this fund is your financial safety net. By preserving it for actual emergencies, you protect yourself from financial setbacks and keep your retirement savings intact.

Remember, creating an emergency fund is a crucial step in achieving financial security and ensuring you're prepared for life's unexpected events.

Consider long-term disability insurance

Long-term disability insurance is an important consideration when using life insurance as a retirement strategy. While life insurance provides financial protection for your dependents in the event of your death, disability insurance protects your income if you become unable to work due to an illness or accident. This ensures that you can continue to meet your financial obligations and maintain your standard of living during an extended period of disability.

There are several options for obtaining long-term disability insurance. Many people may have some disability coverage as an employee benefit. However, it's important to review the details of your employer's plan, as the definition of "disability" and the specific benefits provided can vary. Social Security Disability Insurance (SSDI) is another option, but it can be difficult to qualify for, and the benefits are typically modest.

If you feel that you need additional coverage, you can purchase a private disability insurance policy. There are two main types of disability insurance policies: own-occupation and any-occupation. An own-occupation policy covers you if you can no longer work in your previous field due to a disability, while an any-occupation policy covers you if you can no longer work at all. When shopping for a private disability policy, look for a guaranteed renewable and non-cancellable policy with fixed premiums and no re-qualification requirements.

The amount of disability insurance you need will depend on your individual circumstances. It is generally recommended to have coverage that replaces at least 60% of your after-tax income. Consider your living expenses, such as mortgage payments, car payments, groceries, and childcare, when estimating the benefit amount you would need to maintain your current standard of living.

Additionally, when choosing disability coverage, consider how long you can go without a paycheck. Most group long-term disability plans have an elimination period, ranging from 90 to 180 days, during which no benefits are paid. If you have significant savings, you may opt for a longer elimination period to lower your premiums. The duration of benefit payments also varies, with common maximum benefit periods offered being two years, five years, or until the age of 65.

Life insurance policies may also offer optional riders that can provide additional protection in the event of a disability. For example, the accelerated death benefit rider allows you to access a portion of your policy's death benefit if you are diagnosed with a chronic or terminal illness. The waiver of premium rider allows you to stop making premium payments temporarily if you become totally disabled and unable to work, ensuring that your policy remains in force during a period of financial hardship.

By incorporating long-term disability insurance into your retirement strategy, you can have peace of mind knowing that your income and standard of living are protected, even if an unexpected disability arises.

Invest the rest

Once you have purchased term insurance, created an emergency fund, and bought disability insurance, it's time to invest the rest. This step is a famous saying in the world of personal finance, referring to the difference in cost between a term life policy and a permanent life policy.

If you are saving for retirement, a tax-advantaged retirement account, such as a traditional or Roth IRA, could be your best option, assuming you meet the income limits and other requirements. Alternatively, you could maximise your contributions to your 401(k) or similar plan at work, if you have access to one. It is important to remember that there are penalties for withdrawing from these accounts before you are 59 and a half years old.

If you do not qualify for these types of accounts, you can still invest outside of a retirement account, although you will not benefit from the tax advantages. A low-cost option to consider is an index fund from a mutual fund company or brokerage firm.

Another option is to use life insurance for retirement income. The cash-value account in a permanent life policy grows over time and can be withdrawn as a source of income in retirement, tax-free, as long as the amount withdrawn doesn't exceed the amount paid in premiums. You can also borrow from your cash value, although this will accrue interest and be deducted from the death benefit.

Borrow from your cash value

Borrowing from your cash value is a way to use your life insurance policy as a retirement plan. This is a good option if you have a permanent life insurance policy that has accumulated a significant amount of funds in its cash value. You can borrow from your cash value as a loan to yourself, which will accrue interest and be deducted from the death benefit paid to your family upon your death.

• Interest: The loan will accrue interest, which will need to be paid. The interest rate is typically between 4% and 8% per year and is determined by the policy contract and the carrier.
• No repayment required: Technically, you are not required to repay the loan. However, if you don't, the loan amount, including interest, will be deducted from the death benefit paid to your beneficiaries.
• Impact on death benefit: Borrowing from your cash value will reduce the death benefit paid to your beneficiaries. It's important to consider the impact on your loved ones and ensure they will still receive adequate financial support after your death.
• Alternative to withdrawals: Borrowing from your cash value can be a more flexible option than making withdrawals. Withdrawals may have tax implications if you withdraw more than you've paid in premiums, and they can't be reversed. With a loan, you have the option to repay the money, and you won't owe income tax as long as you pay it back.
• Loan requirements: To apply for a loan against your cash value, you'll typically need to submit a form and verify your identity. Credit or income checks are usually not required since the loan is guaranteed by your policy.
• Loan amount: You can often borrow up to 90% of your policy's value and repay it at your convenience. However, an outstanding loan may reduce your cash value growth, and if the loan balance exceeds the value of your policy, your policy may lapse.
• Impact on cash value growth: An outstanding loan can reduce the growth of your cash value. It's important to regularly check your loan balance and ensure it doesn't exceed your actual cash value amount.
• Lapse risk: If you don't repay the loan before your death, the outstanding balance will be deducted from the death benefit. If the loan balance exceeds the value of your policy, your policy may lapse.

Frequently asked questions