If you ask anyone who is approaching their sixties and furiously trying to build retirement savings from scratch, chances are they will agree with the sentiment, “I wish I had started saving for retirement earlier.”
The importance of starting early is seen in this numerical example. Suppose that you put away $10,000 per year for retirement on each of your 30th through 39th birthdays, a total retirement savings contribution of $100,000, and then stopped saving. Suppose, in contrast, your neighbor puts away $10,000 per year on each of his 40th through 64th birthdays, a total contribution of $250,000. Who will have more money accumulated for retirement at age 65?
The answer – if the money is growing at any interest rate of 5.8% or higher – is that the person who saved $100,000 in his thirties will have more money than the person who saved $250,000 starting just ten years later.
So, starting earlier is better. And, doesn’t that make sense in almost anything you do in life. Most athletes start playing sports when they are particularly young, so doesn’t it makes sense to do the same with your finances. Imagine if Michael Jordan started playing basketball at the age of 21. He probably would never have won six NBA titles. Wayne Gretzky started to skate when he was two years old. You get the idea.
In addition to starting earlier, picking the right product to stash your retirement savings is equally important. And, for many of you, the right product may be a life insurance policy. Different life insurance policies can provide different combinations of death benefit protection and accumulation potential or cash value. The cash value inside an insurance policy gives you the ability to either borrow from the policy or take withdrawals whenever you need money. In fact, it allows you to create more of a cash flow for you and your family, especially while in retirement.
Generally, the more flexibility in premium payments that a life insurance policy provides, the greater your potential for tax-deferred cash value accumulation.
Matching the right policy to your needs depends upon finding the right balance of death benefit protection, flexibility with premiums, risk tolerance, and accumulation potential with which suits you best.
Indexed universal life insurance can fit the bill on many levels. It has been a great retirement planning tool to help clients diversify away from both market loss and paying taxes.
By the way most individuals are unaware of a little-known tax code that’s available to all investors regardless of their income or net worth. The internal code section for this tax break is referred to as IRC 7702. One of its main components is the tax-advantaged growth of the cash value inside of a life insurance policy. If properly structured, you have the opportunity to both grow the money inside the policy as well as have access to this money, before or after age 59 1/2, without ever paying taxes on the gains.
The second tax advantage found in an equity-indexed life contract is that cash value distributions may be accessed from the policy tax-free. If structured properly, policy withdrawals and loans can be used to essentially eliminate income taxes on cash received from the life insurance policy. You can borrow against your life insurance policy, and the loan proceeds are generally not taxable to you. However, the IRS puts limits on contributions to life insurance policies because it realizes the tax benefits of the contracts. There has to be a certain ratio of premium to death benefit to qualify for these tax advantages.
If improperly funded, however, the policy could be considered a Modified Endowment Contract (MEC). A loan from a MEC is treated as a distribution and is subject to the income-out-first rule. As amounts are distributed, they are treated as consisting of taxable income to the extent that they do not exceed the excess of the cash surrender value of the policy over the investment in the contract (generally, premiums paid less tax-free distributions). The taxable income will also be subject to a 10% penalty tax unless the distribution is made after age 59½, on account of disability, or as part of a series of substantially equal periodic payments.
A life insurance policy purchased after June 20, 1988, is a modified endowment contract if the accumulated premiums paid at any time during the first seven years exceed the sum of the net level premiums for a policy that would be paid up after seven years. A single premium policy is one example of a modified endowment contract. Ask a qualified independent life insurance agent to see if a policy is a modified endowment contract.
Indexed Universal Life (IUL) insurance also provides a tax-free death benefit protection, but it has the potential to accumulate cash value based on positive changes in an external market index or a fixed interest allocation. And, as a result it gives you the opportunity for greater accumulation potential than traditional universal life insurance; and the built-in annual floor ensures that the cash value will not decrease due to market volatility. With an IUL the cash value is not directly invested in the market.
Understanding how interest is credited to the cash value in your policy is important.
While it’s a lot like investing directly in the stock market, you don’t get the full boost of a rising market. With an IUL the money in the cash value is not invested directly in the stock market. Instead, there is a limit on how much you can earn on the upside of how much the index gains over a period of time, and a guaranteed minimum return if the stock market declines. The minimum return is never less than zero.
In other words, the cash value in an IUL operates much like a ratchet. Once it hits a certain level it can not be ratcheted back. This can be a huge advantage in historically bad years in the stock market like in 2008 when the Dow Jones Industrial Average was down over 30% . The cash value inside the policy, to put it more simply, is either flat in negative years or up in positive years in the market. Compounding interest is an extremely important concept in building wealth especially if you are young. Not having any yearly negative returns in the stock market makes compounding even more powerful over time. Just ask Albert Einstein about compounding interest, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”
Now, at predetermined times during the life of the policy, you are credited with a percentage of the gain of the index. The schedule varies with depending on pre-determined options. Usually, those options can be changed on an annual basis depending on the stipulations in the insurance contract.
Selecting an Indexed Universal Life policy to help you save for retirement can give you the following benefits:
Death benefit protection: A life insurance plan can provide the retirement fund accumulation that you need, along with a death benefit to provide for your family if there is a premature death. And since you’re young, the cost of the insurance protection is quite modest.
Safe accumulation: A fixed indexed universal life insurance plan credits interest to your cash value based on a market index. If the index increases, you earn interest credits based off of the amount of that increase. If the index decreases, you are protected from the decrease. You are not subject to investment risk.
Protection from future tax rate increases: With a life insurance plan, you have the ability to create a tax-free cash flow in retirement using policy loans that are ultimately repaid by a portion of the death benefit. And the entire death benefit is paid free of income taxes.
You may have never considered life insurance to be a retirement planning solution. When you more closely examine the benefits of fixed indexed universal life insurance, you just may find you’ll want to use it for this purpose.
Keep in mind that most life insurance policies require health underwriting and occasionally financial underwriting.
So start young and think about some of the benefits of using life insurance, such as an IUL, as great way to start planning for retirement.