By Grace S. Yung
When preparing for retirement, there are a variety of different planning strategies that you could consider. However, depending on your annual income, you may or may not qualify for certain options such as contributing to a Roth IRA, with its tax-free distributions that it can offer you in the future.
If you’re single and you earn more than $116,000, or you are married and you and your spouse have a joint income that’s over $183,000 this year, then you may need other tax-deferred avenues of saving for retirement that will also allow potentially tax-advantaged ways of withdrawing funds when the need for retirement income arises.
Finding Balance—Reducing Taxes Now while Being Mindful of the Future
The good news is that even if Uncle Sam won’t allow you to fully benefit from a Roth IRA account, you still have viable alternatives. One option is to take advantage of the potential growth opportunity, the financial confidence, and the tax benefits that may be afforded through an Indexed Universal Life Insurance policy.
Today, life insurance is no longer used just for death-benefit purposes. Rather, if properly designed, life insurance policies can offer additional benefits such as tax-free income, along with long-term care or critical-illness protection. These plans can be seen as another sliver of the overall investment pie that people should consider adding to their overall financial-planning allocation.
When doing so, however, it is important to keep in mind that the performance of the policy’s cash value is dependent on the performance of the underlying market index. As with other types of investments, past performance is not indicative of future gains. In addition, the guarantees on the policy are based on the claims-paying ability of the issuing insurance company, so it is important to choose a strong and highly rated insurance carrier.
How Indexed Universal Life Insurance May Be Used to Fill Your Retirement-Income Needs
Indexed Universal Life Insurance, or IUL, provides both a death benefit and a cash value component. However, the cash within the policy is allowed to grow based on an underlying market index such as the S&P 500 or the Dow Jones Industrial Average. Within an IUL policy, the policyholder is guaranteed a minimum amount of return that is referred to as the “floor.” The floor in the IUL policy helps to guard against market losses in the policy’s cash account.
As an example, if the policy’s cash value is guaranteed not to go below 2 percent in a given year—even if the market returns a negative 10 percent—then the policyholder will still earn a return of 2 percent. In return for this guarantee, IUL policyholders will also have a maximum rate per year that can be earned. This is often referred to as the “cap” rate.
In addition, unlike with a Roth IRA, an IUL policy gives you the opportunity to increase the cash value based on market appreciation, but without the downside market risk. These plans can also provide tax-deferred cash accumulation for retirement, while at the same time providing a death benefit for the financial protection of your spouse, partner, or other loved one.
As with most types of permanent life-insurance plans, the cash value may grow somewhat slowly in an Indexed Universal Life Insurance policy during the first several years of ownership. However, over time, the cash can begin to truly compound. This is why these policies are typically thought to be long-term strategies.
In creating a tax-free retirement income source for the future, you are essentially being mindful of your retirement outlook by taking part in tax-efficient investing now.
Advantages and Considerations
Even if your high income prevents you from participating in the benefits of a Roth IRA account, you don’t have to miss out on the benefits of tax-advantaged investing. With an Indexed Universal Life Insurance policy, you can still obtain many of the advantages that you get with a Roth IRA—and then some.
Advantages – Some of the primary advantages of investing in an Indexed Universal Life Insurance policy can include:
• Tax-free accumulation of funds
• Tax-free distributions
• Tax-free income to beneficiaries
• No requirement for Required Minimum Distributions (RMDs)
In addition, unlike a Roth IRA, there’s no annual contribution maximum (unless the policy is considered to be a Modified Endowment ➝ Contract). In 2015, those contributing to a Roth IRA account can only deposit $5,500 if they’re age 49 and younger. Those who are age 50 and over can deposit an additional $1,000. This contribution limit is not placed on an IUL policy, though. Nor is there an earned-income contributions requirement.
Also, because income can be taken from an IUL policy at any time, these plans can be a great source of tax-free retirement income if you choose to delay Social Security benefits. Each year that you delay your Social Security income between your full retirement age and age 70, you are essentially giving yourself an 8 percent raise.
For example, if your full retirement age is 67, and you delay taking Social Security until you are 70, you can increase your annual Social Security benefit by 24 percent. While waiting to take those benefits, the tax-free income from an IUL policy may be used to bridge the income gap. Then, upon reaching age 70 and starting your Social Security benefits, you can either continue taking the income from your IUL policy or discontinue this income and continue to let the cash in the policy build again.
Considerations – When participating in an Indexed Universal Life Insurance plan, it is important to be mindful of certain factors that could have an impact on how the plan performs, as well as on your overall tax situation.
For instance, it is essential not to let the policy’s cash value go to zero and ultimately lapse the policy. In doing so, you could end up with a substantial tax liability—assuming that there are gains in the policy—which would in turn erase the benefits that you were hoping for.
Also, tax-free distributions will reduce the cash value, as well as the face value of the policy. Therefore, you may need to pay additional premiums into the policy in later years in order to keep the plan in force. So it’s important to minimize the probability of this happening by not over-withdrawing.
In addition, unlike with a Roth IRA account, because an Indexed Universal Life Insurance policy contains a life insurance component, you will be required to qualify both medically and financially for this type of plan.
The good news is that this is only required at the inception of the investment, and once you have been approved—regardless of any health problems down the road—you can lock in your rating for life. With this in mind, the earlier you enter into an Indexed Universal Life Insurance plan, the more time you’ll have to allow your funds to compound over time—and the more likely you’ll be able to qualify based on age and health factors.
Additional Key Benefits
Provided that you qualify, there can be additional benefits to owning an Indexed Universal Life Insurance policy on top of the tax-advantaged savings and income that it features. For example, you can usually add a long-term care rider to the policy that will allow you to take out a multiple of the policy’s death benefit amount in the event of a long-term care need. While this isn’t a complete substitute for purchasing long-term care insurance, it can reduce the burden on your savings or other assets if you should need this costly care down the road.
When considering additional policy benefits, it is important to look at the details. For instance, a long-term care rider may be set up as either reimbursement or indemnity. A plan that is set up as reimbursement will reimburse a policyholder for care—up to the policy’s stated amount—whereas indemnity will pay the set amount stated in the policy, regardless of the actual cost of the care. Although the premium may be slightly higher, in most cases the indemnity method is the better way to go.
Taking the Next Step
As you approach retirement, there are many factors to consider. Certainly, you want to be mindful of any available strategies that allow you to minimize taxes now, as well as to reduce or eliminate taxes going forward.
Working with an advisor can help you to see where your best options are. A professional who has a focus on the LGBT community can provide you with the added benefit of ensuring that your bases are covered, and that you understand the unique considerations faced by LGBT individuals and couples when it comes to both short- and long-term financial planning.
Personal finance-related questions may be emailed to [email protected]
Grace S. Yung, CFP, is a certified financial planner practitioner with experience in helping domestic partners plan their finances since 1994. She is a principal at Midtown Financial LLC in Houston and was recognized as a “Five-Star Wealth Manager” in the 2014 September issue of Texas Monthly.