K
  • February_Risk Insurance_150.jpg

    By Crystal Gifford, Full-Time Faculty  
    Published March 2014

    Traditionally in financial planning, families are urged to have the proper amount of life insurance—usually determined by a formula specific to that family, but a quick analysis usually suggests about ten times the annual income of the household. Planners would sit down with families and have that “tough” conversation about what would happen if the breadwinner(s) died and help them be sure the family is protected in such a case. Current financial planning, however, uses life insurance in a whole new way. Given IRS laws regarding income, and the treatment of “temporary” withdrawals from life insurance as loans rather than income, a whole new area of planning has evolved. This new planning era encourages families to actually save using life insurance as one of the primary mechanisms (Kelly, 2007).

    The process of saving using life insurance can be arranged in various ways, but the most popular among financial advisors, and that suggested by Kelly (2007) is to use a product called “Indexed Universal Life” policies. These policies allow the buyer of the product to put in extra money beyond that of the cost of life insurance in order to build up a savings, in the same basic method that original whole life policies did traditionally. O’Donnell (2013) calls this “massively overfund(ing)” the policy. The difference is that the life insurance is purchased at a minimum amount that still allows the level of savings needed by the family. At any given time, the product allows the investor to take advantage of upswings in the market, with a cap at some percentage—usually 15 percent—while at the same time protecting them from downturns in the market, with a typical lower limit at 0 percent.

    What is the benefit of these policies? It is obvious the major advantage of this is avoiding any drops in the market, so risk is greatly reduced. However, the real advantage comes when it is time to begin using the cash value that has built up in the policy. Because the IRS allows withdrawals from life insurance to be treated as loans from the policy as long as the full balance is not depleted, regular withdrawals can be scheduled so the family can have cash available on a monthly or annual basis to create a sort of “retirement fund.” While the family is withdrawing funds, the “loan” against the policy simply reduces the total benefit that would be paid out at the time of death of the insured. A balance with a large cash value, for instance, may be able to sustain the family through retirement years.

    To be clear, the important part about the loan-versus-income designation is that loans are not taxed by the IRS, while income is. Therefore, a family can live on the funds from the account and avoid paying taxes on that portion of their cash during the year. For instance, consider two families in the same tax bracket (30% for this example). The family withdrawing $75,000 during the year would have $75,000 in disposable funds while the family earning $75,000 income during the same year would have $52,500 in disposable income ($75000 – (75,000 × 30%). This can make an extreme difference when trying to achieve and maintain a lifestyle during retirement. The difference of $22,500 creates an obvious advantage to the family who planned what Kelly (2007) calls a “Tax Free Retirement.”

     

    References

    Kelly, Patrick. (2007). “Tax Free Retirement” ISBN 1425110827.

    Internal Revenue Service. (2014). Retrieved on 01/27/2014. www.irs.gov.

    O’Donnell, Paul. (June 2013). “How to Invest for a (Mostly) Tax-Free Retirement” CNBC Personal Finance. Retrieved on 0127/2014 from http://www.cnbc.com/id/100828497.

    Crystal Gifford is a full-time faculty member at Kaplan University. The views expressed in this article are solely those of the author and do not represent the view of Kaplan University.

     

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