Life Insurance as Part of Your Income Plan

Most of us purchased life insurance when we were young and had a mortgage, and perhaps children, to protect, but it turns out that life insurance can also be a tremendously useful asset for retirees as well.  Here are some of the things you can do with life insurance.

Tax-Free Income

Do you have a whole or universal life policy that you’ve had for years that has a large cash value?  If you do, you have an extra source of income that you may be able to access free of taxes, and that won’t cause your Social Security benefits to be taxed.

You can withdraw cash from your policy up to your cost basis free of income taxes.  You can borrow (usually up to a limit set by your contract) from the policy at low, or possibly even zero, interest (again depends on the terms of your contract).  In most cases, you won’t have to pay it back.

There is a catch however, if you have withdrawn money above your cost basis, it could be subject to income taxes if your policy lapses, thus you need to work with your advisor to insure that this doesn’t happen and that your policy remains in force throughout your life.  Keep in mind that your death benefit will be reduced by the amount of your withdrawals (plus any interest due on loans).

Another bonus, if the policy is owned by another family member (other than your spouse), or a trust, any remaining death benefit will pass to your heirs free of both income and estate taxes.

Supplementing or Replacing Your Pension

If you are about to receive a pension, you may be able to choose to have your payments set up to pay until your death, or to pay until both you and your spouse have passed.  If you elect a payment schedule to last until the second partner dies, your payment will be lower than if it is based on your lifetime alone.

However if payments stop when you pass, and you die first, your spouse may be left without a needed source of income.  One way to replace that income is through life insurance.  If you die first, the death benefit replaces your pension.  If you die last, you will have received the larger pension payment throughout your lifetime, and your other heirs will receive the death benefit.

Combining LTC With Life Insurance

Most of us fear becoming dependent on our children and/or wiping out our financial resources if we become seriously ill and need extended, long-term care.  This is a very real concern as Medicare doesn’t cover most forms of extended care, and there are income and asset limits to be eligible for Medicaid.  Add to this that you probably want the best care possible, and not be limited to a less expensive, Medicaid facility.

However, long-term care insurance (LTC) can be expensive, and like all insurance, if you don’t use it, you lose it.  However, the insurance industry has come up with new products that combine a death benefit, with LTC.   These combination policies offer all the same options as stand-alone LTC insurance, but if you don’t use up your LTC benefit, there is still a death benefit that will pass to your heirs free of income taxes.   In either case, you should get back far more in benefits than the premium paid.

A less expensive option is to add a rider to your life insurance policy that will accelerate the death benefit in case of terminal or serious illness.  In this case, you spend your death benefit before you die. 

Protecting Retirement Accounts From Tax Erosion

You’ve likely worked hard for that large, six or seven figure IRA or 401(k) you have accumulated, and smart investing, combined with tax-deferred growth helped it grow, and should do so well into the future.   As long as you are alive that money will continue to grow tax-deferred and only that which you withdraw will be subject to income taxes.

The problem is that when you die, your money will be subject to income taxation, and if your estate is large enough, estate taxation.  Combined those two forms of taxation can eat away up to 80 percent of the amount over the current estate tax exemption ($1,500,000 this year). 

One way to avoid the estate tax problem, and continue tax-deferred growth is to pass it on to your spouse who can roll it into his or her own IRA without any immediate tax consequence.  However, this does not preserve your estate tax exemption, and upon the death of your spouse, the balance of your account will be considered part of his or her estate.

Another way to delay income taxation, though it might not protect your account from estate taxes is to set up a stretch IRA.

A better way to protect your large retirement account from going to the IRS would be to establish a life insurance trust that can then purchase an insurance policy that will more than make up for any taxes that will have to be paid on your retirement account.  You can use money from other assets if you have it, or pay taxes on the money you withdraw from the account to buy the policy, but either way the cost to do this should be far less than the potential tax bill.

For more ways to protect your IRA and possibly reduce your taxes, click here to order the free booklet, “IRA Distribution Mistakes and how to Avoid Them.”

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