In this post I’m going to revisit Tax-free Retirement Planning with Life Insurance. These are also known as Life Insurance Retirement Plans. I want to revisit this topic for two reasons, first, the United States just surpassed $30 Trillion in total debt yesterday. We need to plan for the day when the government starts to raise taxes in an effort to pay down this debt. In addition, this topic is one of the core fundamentals of maximum over-funded life insurance. It is an important topic to keep in the rotation and come at it from multiple angles.
Goal for this Article
I have two objectives for this post. The first is that I want to show you how a life insurance policy can generate 2 to 3 times the income from the same amount in other forms of savings. Second, I want you to understand how you can use a life insurance illustration to plan for retirement.
2 to 3 Times The Income, Really!
Let’s start with this: 2 to 3 times what? Financial Advisors use The 4-Percent Rule as a Rule-of-thumb for determining the safe withdrawal rate from retirement savings. You want to take as much in income as you can, but you don’t want to run out of money while you are alive. Don’t take my word for this. Go out and do a search on “The 4% Rule”. If anything, the consensus nowadays is that 4% is too high.
You should realize that this means that a person with $1 Million in a 401(k) can safely take $40,000 per year in distributions for as long as they live. Now its important to keep in mind that distributions from a 401(k) (or an IRA, for that matter) are taxed at ordinary income tax rates. So if this person is in a 25% tax bracket, they will lose $10,000 to income taxes leaving them with only $30,000 of annual income for every $1 Million in retirement savings. Even worse, if tax rates are higher, such as 40%, they will only net $24,000 after tax!
If you look closely at a properly-designed, maximum over-funded policy illustration, you will find that the ratio of income to the prior year’s cash value is more like 8%. The cash value of a life insurance policy can generate income at about an 8% ratio. Take a look at this footnote for caveats and assumptions.
What this means is that someone with $1 Million in cash value at retirement age could safely take $80,000 per year in TAX-FREE Income. It should be obvious that $80,000 is about 3 times the after-tax income of what our hypothetical $1 Million 401(k) can generate depending on the tax rate.
So I’ve just spent a few paragraphs showing you what is possible. Now I want to explain to you HOW this is possible.
How Is It Possible To Get Twice The Income From The Same Amount Of Savings?
This is what every pundit gets wrong. They just don’t understand how to convert cash value into “income”. The “so-called” experts simply compare accumulation. If a tech mutual fund is growing at 10% per year, you are going to end up with a lot more money by the time you reach retirement age. The problem is that most pundits don’t understand that life insurance cash value can provide twice the income.
How is this possible? The one thing that I realized is very powerful, is that you do not TAKE any money OUT of a life insurance policy to generate income. You take advantage of the ability to borrow against the policy to access your cash value tax-free. It is also important to understand that taking income via policy loans is the reason that the income is tax-free. You do not pay tax on money that you borrow. While this may seem counter-intuitive, you need to understand and fully appreciate that the entire amount of cash value is still growing and earning interest or dividend credits.
When you take a $40,000 distribution from our hypothetical $1 million 401(k), the base is reduced to $960,000. As you’ll see below when we look at an illustration, when you take $80,000 of income from a life insurance policy, the cash value grows to $1,055,000. See the difference? Policy loans are very powerful.
Insurance companies are required by state statutes in all 50 states to make loans to their policy owners secured by the cash value of the policy. This isn’t some “Trick”. It’s just how you get income from a life insurance policy. Even better, the statutes go on to state that if the policy owner fails to pay the interest on the loan, the insurance company shall loan them the money to pay themselves the interest. Try that with your mortgage lender!
Because you are financing your interest, you will have a growing and compounding loan balance. Don’t let that compounding loan balance intimidate you. It is important to keep in mind that the cash value is also still growing and compounding. This means that the growing loan balance is always secured by the growing cash value. And if there is positive interest rate arbitrage, then the cash value will outpace the loan balance.
Let’s Look At An Illustration
Your head is probably hurting at this point. It might help to take a look at some numbers to appreciate the concept.
I ran a quick illustration for a maximum over-funded IUL policy on a 45 year old male non-smoker. The policy owner is paying a $25,000 premium annually to a “traditional” retirement age of 65.
Income to Cash Value Ratio
I hope you’ve already pulled your calculators out and divided the income by the cash value. That would mean you’re paying attention and you want to see the proof. However, this is an extract from an “official” illustration. I like to be conservative when I am showing numbers to a prospective client. I would much rather that you be pleased because your policy outperformed the assumptions than upset because it did not.
If you divide the income ($65,613) by the Age 65 end of year cash value ($904,591), the result is 6.92%. The reason that the income is less than the 8% that I claimed above is that I am using a 5% loan rate on the loan balances while assuming 5.49% cash value interest crediting. This is just less than 1/2 percent of arbitrage.
You should realize that with current interest rates on policy loans at only 3%, this policy could generate much more income that what is illustrated here because the actual arbitrage would be higher. However, when I’m running an illustration today, to show to someone retiring 20 years from now, I want my assumptions to be conservative. This particular policy has an indexed loan option that will never exceed 5%. So that is the rate I am assuming for 20 years in the future.
Relationship Between Cap Rates and Interest Rates
It is very unlikely that the interest rates would be high while the cap rates are low. You should also understand the relationship between the Cap Rates on IULs and interest rates. The reason that cap rates are so low right now is that interest rates are so low right now. If interest rates begin to rise, the we will see cap rates rise too. What I’m getting at is if interest rates rise enough to use the indexed loan option, then the interest rate arbitrage will be higher in the future too because the Caps Rates will be higher.
I hope you have noticed that the income projection is still 6.92% even with only 0.49% of interest rate arbitrage! It should be clear that even in my very unlikely scenario here, that the policy can still provide much more income than our hypothetical 401(k) above.
You should also be aware that even though I’m not showing the bottom half of the illustration, the income runs out all the way through Age 120. What this means is that the insured is very unlikely to outlive their income.
Cash Value Keeps Growing
The last thing that I want you to notice is the Cash Value and the Surrender Value at years 21 and 22. If you look at the cash value column, you can see that even though the illustration is showing loans of $65,613 every year, the CASH VALUE IS STILL GROWING. You will see that the surrender value is going down to show the net that the policy-owner would get back if they surrendered the policy. Any loans would have to be settled from the cash value.
It is also important to understand that the death benefit is SHOWING what the beneficiary will receive AFTER THE LOANS ARE PAID OFF FROM THE DEATH BENEFIT. This is not clearly labeled on life insurance illustrations. Policy loans do not lower the death benefit as many agents think. Policy loans reduce the NET death benefit the beneficiary will receive once the loans are settled. This is a very subtle but important distinction. The death benefit is ALWAYS higher than the cash value.
Tax-free Retirement Planning
An illustration is a very useful tool for showing someone just how much money they need to put away in order to enjoy the retirement they want. Its important to realize that everything in life insurance is scalable. This means that if you double the premium, you will double the cash value, the death benefit, and the retirement income projections. This allows you to easily see the relationship between savings and future income.
There are a lot of moving parts to consider in retirement planning. The list below is not meant to be exclusive:
Cost of housing
Quality of life
Rate of savings
Existing Retirement Plan/Pension
If, after careful consideration of your future income needs, the illustration is not showing enough income, then you can easily back into the amount that is necessary by adjusting the premium. If you can’t afford that number now, will you make up for it and the lost compounding by increasing savings later?
In this post I have showed you how you can get two to three times the income from the cash value of a maximum over-funded life insurance policy compared to a similar amount in some other retirement asset. I’ve also showed you how you can use an illustration to back into the premium or savings necessary to achieve your future income goals.
Two Economic Powers Approach to Retirement Income Planning