Using Life Insurance to Supplement Retirement Income

Reasons for Life Insurance

When it comes to putting aside funds for a Business Owner’s retirement, the options beyond qualified plans are limited.  Owners of pass through entities are taxed on the profits of their business regardless of what they do with the Company’s money.  To build a source of retirement income that grows tax-deferred and could potentially provide an income tax-favored source of funds in retirement, business owners often turn to a cash value permanent life insurance policy.  Beyond the lifetime tax benefits, life insurance is favored for its self-completing nature through the death benefit in the event of a pre-mature death, and its ability to accumulate a stable source of cash that can be invested in either fixed or variable products, depending on the client’s risk tolerance.

One of the most basic principles of life insurance income taxation is that in the absence of a Modified Endowment Contract (MEC) status, distributions to the owner of a cash value life insurance generally comes first from basis.  If the policy is owned by the Executive or the Business Owner, it can provide an income tax-free stream of income at retirement up to certain limits.  The reason for the income tax-free treatment is that (a) the premiums are paid with after tax funds, and (b) the basis first treatment is specifically provided or under Internal Revenue Code.

In addition to the ability to withdrawal basis before gain in a life insurance policy, owners have the option to receive policy loans, also free of income tax, provided the policy is not a MEC.  The reason for this treatment is that a loan, by definition, is subject to a repayment requirement and bares interest.

The availability to receive policy loans without triggering income tax can be an attractive benefit as well as an income tax trap.  If policy loans and interest accumulate to the point that the policy no longer has sufficient cash value to sustain the loans and support a death benefit, the policy can lapse, or the owner can be forced to surrender it.  If this happens, the entire gain in the policy is taxed as ordinary income.

In addition to the features and protections described above, it is important to structure the policy ownership properly when the goal is to accumulate cash values for retirement income.  If the policy is owned by an employer during the accumulation phase, it will need to be transferred at some point to the individual who will be using it for retirement income.  This transfer will trigger income (compensation income, in the case of a non-owner executive) on the fair market value of the contract in the year of distribution.

Cash value life insurance as an accumulation tool for retirement income can offer many benefits, including income tax savings, death benefit protection, and steady growth potential.  With available protections and automated features, it can also help improve the likelihood of avoiding unpleasant income tax surprises.