As you get older, threats to your financial security increase. Factors such as inflation, market volatility, and soaring healthcare costs are challenging to control for, and we never know what taxes will be like in the future. An Indexed Universal Life (IUL) insurance policy can stabilize your retirement portfolio by reducing risk and providing tax-free growth.
Indexed Universal Life (IUL) insurance represents a form of permanent life insurance that ensures a death benefit for your designated beneficiaries. It incorporates a cash-value element that has the potential for growth over time.
Unlike many other insurance policies requiring continuous premium payments to prevent the policy from lapsing, an IUL offers greater flexibility. Should your policy’s cash value accumulate substantially enough to cover policy costs, you can modify or even cease your premium payments.
So, how does it help in retirement planning?
IUL policies provide downside protection, referred to as a 0% floor. Your cash value never goes down due to market losses because your cash value is not in the market. After policy expenses, the remaining cash value, minus a small portion for the purchase of a call option, stays in a stable account, earning interest so that in a year, it is credited to equal the amount spent on the option.
The small portion of the cash value purchasing an option on an index, like the S&P 500, caps the amount of interest the policy may gain for that portion of cash value. If the market index retreats, the cost of the option is lost, but no cash value is. So a year later, if the market is up and interest is credited, the process starts again with a larger amount for the new time period. If the market is down and no interest is credited, the process would begin with the previous amount.
So, the cash value can only go up or sideways, thus protecting against any market losses! This stability reduces market risk in an overall portfolio by providing downside protection, making it extremely powerful in a severe market downturn or for people that are near tapping their money and do not want it to fluctuate.
Of course, if premiums are not paid, policy expenses will be taken from the cash value to keep the policy in force.
Usually, you have to pay some kind of tax when you invest in securities. For example, in a brokerage account, you will have to pay long- or short-term capital gains taxes when you sell a stock for more than you purchased it, depending on how long you held it. When you start withdrawing from your 401(K) or IRA (as long as they’re not Roth), you will pay income taxes on your withdrawals.
With an IUL policy, you are actually not withdrawing anything. You’re taking loans from the insurance company using your life insurance policy as collateral. As long as you adhere to the IRS Modified Endowment Contract (MEC) guidelines, which limit the amount of money you can put into the policy, any money you take out, including through policy loans, will be completely tax-free!
For example, let’s imagine that a policy’s death benefit is $1,000,000, and it has a corresponding amount of cash value built up in the policy. At age 75, you begin pulling $5,000 per month from it for eight years for a total of $480,000. If you passed away at age 83, you will not owe taxes on the $480,000, and your beneficiaries will receive the remaining death benefit of $320,000, also completely tax-free.
Another important aspect of IUL policies is the potential for positive arbitrage. Positive arbitrage occurs when the interest credited to the policy’s cash value outpaces the loan interest rate. It means that the returns you’re earning on your policy’s cash value are higher than the interest you’re being charged on the loans you’ve taken from it.
If your IUL policy experiences positive arbitrage, your money is working harder for you, even as you borrow against the policy’s cash value. The credited interest continues to compound on the entire cash value, not reduced by the loan amount, thus creating a potential scenario where you’re effectively making money on borrowed funds. In this case, it could significantly enhance your retirement income.
The possibility of positive arbitrage with an IUL policy can be attractive for retirees looking to maximize their retirement income. However, it’s important to note that this is not a guaranteed outcome and depends on the performance of the index the policy is tracking and the specifics of the policy terms.
When you retire and start taking funds out of your retirement savings, whether a Traditional 401(K), Traditional IRA, or another pre-tax account, you must pay taxes on those distributions. However, you may be able to recoup those taxes by using them to pay the premiums on an IUL policy.
The rationale lies in funding the policy over several years with the anticipation of its good performance. In this scenario, you stand to experience positive arbitrage, potentially not only recovering the taxes you paid but plus some.
This IUL strategy flips the tax mitigation strategy on its head. Instead of using your distributions to pay for premiums that will recover your taxes, it uses policy loans to pay your taxes. It is particularly beneficial if tax rates increase in your later years and you cannot afford to pay the increased taxes.
There is one method that can supercharge an IUL using leverage. In this advanced strategy, the premiums you put into the policy are matched by a bank, allowing the cash value to grow much faster. A leveraged IUL can be particularly useful for those beginning to save for retirement late in the game.
The amount you receive from Social Security directly correlates to your income. If your full retirement age is 67, you can start receiving benefits before then and even continue to work, but there will be penalties if you earn too much.
However, a loan from your death benefit will not count as income, giving you more flexibility in choosing where to take your income. For example, you can work and earn up to the limit, receive your social security payment, and supplement your overall income with loans from your IUL.
IUL policies allow you to adjust the amount and frequency of your premium payments within certain limits. It can be beneficial if your financial situation changes and you must increase or decrease the amount you pay into the policy. You may also be able to pause paying premiums entirely if you’ve built enough cash value to cover the monthly insurance cost.
You can usually modify the death benefit amount within the policy’s terms, allowing you to increase or decrease coverage as your needs change over time.
Many IUL policies offer optional riders that can be added to the policy for additional benefits and flexibility, such as accelerated death benefits or long-term care coverage.
Nowadays, most IUL policies include living benefits, such as chronic, critical, or terminal illness benefits, which, if you have a life-impairing illness, allow you to access a portion of your death benefit while you are still living. This money can be used to pay for medical care or whatever you want!
There’s no such thing as a free lunch, meaning you’re paying higher fees in exchange for the stability, flexibility, and tax advantages an IUL provides. However, those high fees typically only last the first five or ten years – remember, IULs are long-term vehicles. When viewed over an extended period, these fees, on a percentage basis, can be lower than those associated with investment management.
That said, an IUL is not a replacement for any other investment strategies but rather a complementary one, filling that gap in your portfolio between your high-risk, high-reward stocks and low-risk, low-reward bonds.
Also, IUL policies can be pretty complex, so reviewing potential strategies with a financial advisor is vital. An advisor can help you look at the bigger picture and determine if an IUL has a place in your retirement and tax plan.
We’ve helped many clients navigate life insurance policies, so if you have any questions regarding life insurance strategies, we’d love to help you determine if they’re the right fit for you.
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