[Today’s post is educational only and is not financial, tax, or legal advice. The full disclosure statement is found here.]
An Introduction: It Isn’t A Question
Saving for retirement is critical for nearly every American, and there are many ways to do so. One of the most popular methods is utilizing the Individual Retirement Account, also known as the IRA. However, as I covered previously, some advocate that permanent life insurance can be a better vessel to reach your retirement goals. While such debate has run amok for decades, it is primarily a non-sequitur fallacy.
Non-sequitur definition: An inference that does not follow from the premise.
Example: Permanent life insurance is a better choice than the IRA since it forces people to save.
While permanent life insurance forces people to save, that doesn’t intrinsically make it of value.
First, you are responsible for your spending and saving habits. Own up to the challenge; you don’t need an account that forces you.
Second, permanent life insurance isn’t saving. Such statements are cum hoc, ergo propter hoc fallacies at best.
Cum hoc, ergo propter hoc fallacy: With this, therefore, because of this.
Example: Because permanent life insurance has a cash value component, it can be used to save for retirement.
Life insurance is insurance, and borrowing or withdrawing from a policy reduces the death benefit.
Additionally, loans and withdraws affect performance and can only be made tax-free up to specified amounts.
Finally, if funds are withdrawn too frequently and not replenished, the policy may be terminated.
Thus, life insurance as an investment is usually ill-advised at best, harmful at worst. And I say this as someone who has worked in both industries, albeit briefly in the former.
So, what is permanent life insurance for then? Estate planning primarily.
Nonetheless, I want to give air to this misconception and flesh out the benefits and drawbacks of saving for retirement through IRAs and permanent life insurance policies. Then you can decide for yourself which is best to achieve your financial goals.
How to evaluate
Like my post on evaluating an old 401(k), you need to ensure you EXPLORE all of your options before making a haste decision concerning IRAs and permanent insurance. The primary evaluation factors include:
Ex – Expenses
P – Protections
L – Liquidations
O – Options
R – RMDs
E – Excise
Expenses: Fees and other costs
IRAs: Many IRA providers do not charge a fee to open and maintain an account nowadays, though this was not always the case, and some still do, so be sure to check before opening one! Additionally, most providers have eliminated commissions on stock & ETF trades while offering many index mutual funds without transaction fees. Lastly, you can pay anywhere from 0.3% to 2% if you want a managed account. However, some advisors charge more and sell you into loaded mutual funds, so be mindful by using these steps.
Permanent life insurance: Generally, fees include mortality, expense, sales, administrative, rider, and withdrawal surcharges, plus surrender charges if you cancel your policy. There are no average industry fees to quote due to the various types of policies and the unique nature of each. Still, it is widely known insurance costs more than traditional investments, with fees over 3% annually. After all, you are the product, and the insurance company needs to make a profit to make this endeavor worthwhile (they are guaranteed to payout in the future).
Winner: IRAs offer lower expenses than permanent life insurance, and you have more flexibility in choosing which fees to pay.
Protections: Creditors beware
IRAs: IRAs usually offer protection against creditors (i.e., debt collectors & judgments against you) in bankruptcy only. However, some states afford unlimited creditor protection to them, such as California. Significantly, if you owe the IRS or are going through a divorce, your IRA is not shielded.
Insurance: Permanent life insurance regularly provides creditor protection on the state and federal levels to a varying degree. The degree to which your cash value is protected varies from state to state. Some jurisdictions offer complete protection while others set a specified monetary limit. Significantly, the IRS cannot levy your cash value, but it can be split amongst participants in divorces.
Winner: It depends on the state of residence to decide which offers the best protection, but permanent life insurance provides more uniform protection nationwide. However, if you genuinely have creditor problems, 401(k)s offer the most extensive protections due to ERISA. If you have creditor concerns, be sure to talk to a lawyer for advice.
Liquidations: Withdrawals and more
IRAs: Self-directed IRAs offer complete flexibility for withdrawals of any amount and frequency, but some providers may have limitations. In contrast, managed IRAs often limit the frequency and value of withdrawals. If you are under age 59.5 and do not have an exemption, you will be penalized for any money removed. Formally known as the early withdraw penalty, it levies an additional 10% tax on any traditional IRA withdrawals. However, for Roth IRAs, only gains are penalized, as contributions and conversions can be removed after five years. Significantly, if you are under 59.5, any gains withdrawn are taxed from Roth accounts.
Insurance: Withdrawal options vary by policy, but usually, permanent life insurance offers four choices: Regular, loan, premium elimination, and surrender withdrawals. While alive, you can only remove money accumulated in the cash value bucket of the policy. Any sums drawn exceeding contributions are taxed as ordinary income and penalized 10% if under age 59.5. Loans remain tax and penalty-free when repaid. If any loans default while alive or the policy is surrendered, you may owe income taxes and penalties. When you pass, any loans or withdrawals against the cash value are deducted from the death benefit paid to your beneficiaries, and no taxes or penalties are owed. However, the insurance company keeps any remaining cash value. Lastly, premium elimination is the process of using cash value to pay premiums without taxes or penalties, essentially creating an autonomous plan.
Transferring: IRAs can be rolled over infinite times to other providers or once per year for 60-day cash rollovers. Depending on the investments, some can be moved from provider to provider without selling them. There are no taxes or penalties for doing an IRA rollover. However, some firms may charge a fee to leave. With life insurance, policies are designed to be permanent. Notably, you can do a 1035 exchange from one provider to another, assuming you qualify new for coverage. But, you will incur high costs by starting anew, and not all of your cash value that transfers over will be accessible.
Winner: IRAs offer greater withdrawal flexibility and are more portable when changing providers. However, permanent life insurance cash value can be easier to access during times of short-term liquidity needs.
Options: Investments and more
IRAs: IRAs offer the flexibility to invest in stocks, bonds, ETFs, mutual funds, options, REITs, annuities, CDs, physical real estate, private placements, gold, cryptocurrency, and more. Some investments will offer little to no return to preserve principal, while others may increase substantially at the risk of turning into dust. Hence, the reward is married to the risk. And for those who do not want to manage their accounts, professional management is an option.
Insurance: Investment options are determined by the issuer and usually include choices that track current interest rates, offer guaranteed growth, or participate in proprietary mutual funds. Generally, permanent life insurance investments offer safe but lower returns (similar to annuities) and no control once the policy is in force. There is no such thing as self-directed permanent life insurance.
Winner: IRAs offer more investment choices with varying levels of control, depending on an investor’s needs and risk tolerance.
RMDs: Required withdraws
IRAs: Traditional IRAs require annual withdraws once you turn 72, as the government wants their cut of your deferred tax dollars. Roth IRAs have no RMD requirements.
Insurance: You are never required to withdraw from permanent life insurance cash value.
Winner: Permanent life insurance
Excise: Taxes due and contributions
IRAs: With IRAs, there are traditional and Roth flavors. Traditional IRAs give a tax deduction and grow tax-deferred depending on income and employment situation. At withdrawal, ordinary income taxes are paid on each dollar removed. With Roth IRAs, taxes are paid now and in the future can be withdrawn tax-free. If you don’t qualify for a Roth IRA, you can do backdoor Roth conversions. Both IRAs have a combined limit of $6,000 annually and allow for $1,000 catch-up contributions for those 50+. Traditional IRAs are taxable to your heirs, and Roth IRAs are not (if the money has been in the account for at least five years).
Insurance: Withdraws are not taxable up to the amount you have paid in premiums, but any amounts over are taxed as ordinary income. There is no contribution limit, but all contributions are post-tax. Life insurance is not taxable to heirs at death, but any residual cash value is forfeited to the insurer.
Winner: It depends on your situation. IRAs initially offer more control over taxes, but traditional and Roth are considered part of your taxable estate at death, unlike insurance. If your wealth exceeds $12 million as an individual or $24 million for married people, permanent life insurance could be more meaningful.
+1 to each IRAs and Insurance
So, which is better?
And the results are in +4 IRAs and +3 Insurance
The winner is… the IRA!
Sometimes it varies
Based on everything discussed, if you have to choose between saving in an IRA or a permanent life insurance policy, generally, an IRA is the better bet. Notably, that doesn’t mean skipping insurance coverage. But instead, it means purchasing a term policy to cover your family’s financial needs.
However, this is general information, and your situation could vary!
Example 1: Do you live in California, have a net worth under $12 million, and have a Roth IRA? Then IRAs win 6 to 2 over insurance. CA offers unlimited creditor protection to IRAs. You would have no RMDs, and you wouldn’t be subject to the estate tax limit.
Example 2: Do you live in Maine and have a net worth of $36 million? Traditional IRAs are protected up to $15,000, cash value life insurance is protected up to $4,000, and Roth IRAs are not protected. Additionally, your estate will be taxed at nearly 40%. However, you can buy a permanent life insurance policy that pays out enough to offset the expected taxes, and there is no contribution limit. Heirs don’t have to liquidate accrued wealth in such a scenario, but you lose to creditors no matter what.
•Investment brokers & advisors are held to a higher ethical standard than life insurance brokers, agents, and advisors. Importantly, that is not to say life insurance advisors lack morality.
•Additionally, they do not have to disclose all relevant risks like investment advisor recommendations.
•Notwithstanding, there are plenty of ways your investment advisor can take advantage of you. However, investment providers must make suitable recommendations in your best interest and adequately disclose any risks and compensation sources involved.
Saving for retirement and protecting your family is equally important. Find what works best for you!
Life insurance is essential, and so is saving retirement. However, for most, term insurance and an IRA will be the best way to build wealth. While the allures of forced saving through permanent life insurance or the safer returns it can provide may sound alluring, IRAs can offer substantially more choices, and self-discipline is essential if you are to get anywhere in life.
But, what do you think? Do you agree or disagree? Let me know in the comments below, and tell me of the experiences you have had with either.
As always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time