Divorce the IRS

Should You Use Life Insurance for Retirement Income?

• James Miller

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Many retirees and high-income earners are constantly searching for ways to build more tax-free income in retirement. One strategy that often enters the conversation is the Life Insurance Retirement Plan, better known as a LIRP. 

Proponents often market LIRPs as a powerful way to create tax-free retirement income while maintaining life insurance protection. But are they really as good as advertised?

In this episode of The Divorce the IRS Podcast, we take an objective look at Life Insurance Retirement Plans, including how they work, who they're designed for, and the risks that are often left out of the sales presentation. 

We explore the evolution of cash value life insurance from Whole Life to Universal Life, Variable Universal Life (VUL), and Indexed Universal Life (IUL), and discuss why IUL policies have become the most common structure used for modern LIRP strategies. 

You'll learn how these policies generate tax-deferred growth, how tax-free policy loans are used to create retirement income, and why proper funding and ongoing management are critical to success. We also cover the potential drawbacks, including policy costs, surrender charges, underwriting requirements, Modified Endowment Contract (MEC) rules, policy lapse risks, and the limitations that come with indexed crediting strategies. 

Most importantly, we discuss who should consider a LIRP and why, for many investors, there may be better tax-free options to explore first before turning to life insurance as a retirement planning tool. 

If you've ever been pitched a LIRP, IUL, or cash value life insurance policy as a retirement strategy, this episode will help you understand the benefits, the risks, and whether it deserves a place in your financial plan.

In This Episode

• What a Life Insurance Retirement Plan (LIRP) is
• How cash value life insurance differs from term life insurance
• The evolution of Whole Life, Universal Life, VUL, and IUL policies
• Why Indexed Universal Life (IUL) is commonly used for LIRP strategies
• How tax-deferred growth and tax-free policy loans work
• The underwriting requirements needed to qualify for coverage
• Why LIRPs should typically be considered only after other tax-advantaged strategies have been exhausted
• The importance of fully funding a policy for long-term success
• Common mistakes that cause LIRPs to underperform
• How policy fees, insurance costs, and administrative charges impact returns
• What a Modified Endowment Contract (MEC) is and why it matters
• The tax consequences of policy lapses and excessive borrowing
• How insurance companies control participation rates and caps within IUL policies
• Why investors do not receive dividends from underlying index investments
• The impact of surrender charges and long holding periods
• Who may be a good candidate for a LIRP and who probably is not
• Why proper planning and ongoing management are critical to making a LIRP work

What's Coming Next

• Advanced retirement income planning strategies
• Tax-efficient withdrawal strategies in retirement
• Why dividends matter more than many investors realize
• Divorce the IRS and FIRE: Tax planning for the Financial Independence, Retire Early movement
• Real estate considerations in retirement planning
• Divorce the IRS and "Die Broke": Rethinking wealth, legacy, and retirement spending

Life Insurance Retirement Plans can be powerful tools in the right circumstances, but they are far from a one-size-fits-all solution. Understanding the costs, risks, and limitations before committing to a policy can help you avoid expensive mistakes and determine whether a LIRP truly belongs in your retirement strategy.


SPEAKER_00

Welcome to the Divorce the IRS Podcast, the retirement income planning podcast designed specifically for those who want to pay the least amount of taxes possible and build a retirement income that lasts. Inspired by the best-selling book, Divorce the IRS, you get to go behind the scenes with financial planner, author, and speaker Jimmy Miller. Learn how to set yourself up to pay the least amount of taxes in retirement when you'll need your money the most. And now, here's your host, Jimmy Miller.

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Welcome. Welcome to episode 25 of the Divorce the IRS podcast. Today, we switch gears again and get into a very different type of tax-free investment slash product. Life insurance as an investment vehicle for tax-free retirement income. So let's dive right in. Life insurance retirement plans, or LERPS for short, have been around for some time and they seem to come and go in popularity. Their popularity appears to be directly correlated with how many life insurance salespeople are outselling them. To be honest, I'm torn on the effectiveness of LERPS. I've seen a few work well and I've seen many of them fail, costing people a lot of their hard-earned money. They are worth mentioning though, so in this episode, I'm going to point out all the benefits, pitfalls, and who should and should not consider them. First, let's quickly discuss how a cash value life insurance policy is structured and how it works. It's basically made up of two components, an investment account and a term life insurance policy. You put money into the investment account, and then the life insurance company takes all of its costs, charges, fees, loads, etc., from the investment account. As long as there's money in the investment account for the insurance company to take money from, the policy is good and stays valid. Depending on the type of insurance policy you buy, the rules for the investment account can change. Now there have been many flavors of LERPS over the years. They started with the old whole life policies, which are still around. However, people were not happy with the low savings rate types of returns that these policies provided. So the next version to emerge was called Universal Life. This allowed you to invest in the insurance company's investment portfolio, which was usually bonds, and earn a little bit higher rate of return than what the whole life policies offered. Next came variable universal life policies, or VULs. People wanted to control their own investing and choose investments tied to the stock and bond markets. The VUL allowed people to choose from a myriad of mutual fund portfolios called subaccounts and life insurance within their life insurance policies. The insured bore all of the investment risk in these policies, and many of these policies failed over the years because of that very reason. The latest flavor of LERP uses something called Indexed Universal Life, or IUL for short. With these, you split the investment risk with the insurance company, usually by investing in a stock index with a limit on the amount you can earn over a stated period of time. For example, you might invest in the SP 500 index, and the most you can make in a year is 10%. So if the market goes up 20%, all you will make is 10%. If the market goes up 5%, then you will make the full 5%, and so on. In return for capping what you can make on the upside, there is no chance of a negative return if the index goes south. This risk falls onto the insurance company. So for example, if the market goes down 20% in a year, you wouldn't lose any money in your investment, or gain any money either. The insurance company eats the losses, so to speak. You're giving up some upside beyond the 10% cap, and that's the price for this downside benefit. The end result is that an IUL takes some of the investment risk off the table for you and is more predictable to plan with. These IUL policies draw on the strengths of all the previous versions of permanent cash value life insurance and are generally the most suitable type of policy to use for a LERP today. Now the key difference between all these policies and regular term life insurance is that they have an investment component. The general goal of term life insurance is to purchase the greatest amount of death benefit for the least amount of money. The opposite is true for cash value policies used for LERP purposes. You want to put the absolute greatest amount of money in and buy the least amount of insurance allowed by law, since the primary purpose of a LERP is to be a tax-free investment vehicle. With LERPS, there are a lot of factors to consider. The first thing worth mentioning about LERPS is that you need to qualify for the life insurance component. This is, first and foremost, a life insurance policy. And to get any cash value life insurance policy, you must go through something called underwriting. This is when the life insurance company asks you to complete a physical, usually taking blood and urine, to determine your overall health and decide whether you qualify for the life insurance and at what rate, depending on your overall health and mortality risk. This is the first hurdle that must be crossed for you to even consider a LERP. Second, you really should have a need to purchase life insurance, as well as a plan for retirement. This is a life insurance policy, after all, and you will be paying money every month from the investment in the policy to the insurance company for the insurance coverage. This amount can be substantial and depends on both your age and the level of your health. There are often other costs associated with these types of life insurance policies as well that you'll need to consider, such as administration, policy, and investment load charges. So, assuming you need life insurance and you qualify for it at a rate you're happy to pay, there are a couple of other factors to consider. Many life insurance salespeople would adamantly disagree, but I believe LERP should be the last place used to stash money in the tax-free bucket for retirement planning. Lerps are generally only for those people who have one, maxed out their Roth 401k at work. Two, maxed out their personal Roth, usually via the backdoor strategy. Third, maxed out after tax contributions they can make to their workplace plan via the mega backdoor Roth strategy. Fourth, completed all the Roth conversions available to them down to their ideal number. Fifth, maxed out any self-employment retirement plan they can contribute to. Sixth, maxed out their ideal number for the tax deferred bucket. And finally, accumulated too much money, too much retirement money in the non-qualified Tax Me Now bucket. As you can imagine, ticking off all these requirements generally knocks most people out of the running for considering a LERP. But for those who meet all the requirements and still have significant sums of money available to save, a LERP can be a good option when done correctly. If you're going to consider a LERP, please make sure that you have the money to fund it to the maximum for the amount of insurance you're purchasing. These plans work best when they are fully funded and you put as much money into them as allowed by law. This gives the plan the best chance for compounded growth and overcoming all the costs associated with the policies. I have seen too many people get talked into purchasing alert policy and they're told that they can just put in a little bit of money and save more over time. This information usually comes from a salesperson who can only sell, well you guessed it, life insurance. If the only tool you have or can sell is a hammer, everything out there looks like a nail. Please consider this analogy when listening to a life insurance hammer only salesperson. It's best to purchase a LERP from a tax-free fiduciary planning specialist, not a life insurance salesperson. And only if you meet all of the criteria previously mentioned. A fiduciary planner can usually shop around to all the life insurance companies and will know where the best deals can be found on LERP policies. When you only put a small amount of money into a LERP, the ongoing cost for insurance and other charges usually eats up all the growth potential of the policy. You continue to feed the policy with your hard-earned money, and in turn, the policy feeds the hungry fees of the insurance company. And in the end, the life insurance company has all the money you contributed, the insurance salesperson makes a big commission, and you don't have much of anything. If you do have the money to properly purchase and fund a LERP, that's great. So why does this work so well as a tax-free investment and how do you use it for tax-free income and retirement? See, the government likes to encourage people to purchase life insurance. It's better for the government to have a widow or widower receive a big tax-free life insurance check when the breadwinner passes rather than be forced into welfare programs. So to encourage life insurance, the federal government allows within limits the cash value investments inside life insurance policies to grow tax deferred. You're allowed to borrow against these investments tax free from the insurance company with the investments as collateral. Now that sounds a bit complicated, doesn't it? It's because it is, and this is a big deterrent to using LERPS. Managing all the moving parts of a LERP is complicated, and it's best done by a good financial planner who utilizes LERPS on a regular basis. Done incorrectly, these plans can become tax nightmares, not the tax free investments you originally planned for them to be. For example, if you put even one dollar too much into a LERP over the limit, it becomes something called a modified endowment contract or a MEC policy and loses the tax-free status you were planning on. Whoops. If you borrow too much from a LERP or stop funding your LERP and the life insurance policy lapses, everything you ever took out of the policy above your cost basis becomes taxable to you in that year and the plan blows up. Another whoops. The insurance company also has the right to lower the cap over time on the maximum amount you can earn from the indexes in IUL policies. You cannot control this. It's set by the insurance company. And if they do this, and they often do, your earning potential can be severely limited. They can't change the fact that you cannot lose any money in the index, though. This fact is protected and valuable. You also need to understand that you won't participate in any of the payable dividends from the companies in the index you choose. The most popular index used in LERPS is the SP 500, which is a market capitalization weighted price index composed of the 500 widely held common stocks headquartered in North America. Although this is the stated index, you don't actually invest directly into it, and thus you don't receive any of the dividends from the companies in the index. Dividends on the SP 500 are a large component of the long-term growth of the index, and you will always be missing out on that component within an IUL policy used as a LERP, or any annuity that uses this investment strategy as well. Unfortunately, this inconvenient fact is always left out of any sales presentation given on an index investment, like life insurance or annuities. And we'll explore this important issue in detail in the next episode. Now these plans also come with long surrender charges, meaning you cannot cancel or get your money out of them without big penalties from the insurance company. Most insurance companies have a 10-year surrender penalty on their policies, and I have seen some as long as 15 or 20 years in my career. Now my goal isn't to scare you away from a LERP, at least not entirely anyway. I just want you to understand some of the risks and who the plan is really designed to help. If you make a million dollars a year, a LERP and a good planner is probably right for you. If I can help just one person who shouldn't buy a LERP avoid buying it, the time it took to produce this whole podcast will have been worth it for me. I hate to see people purchase bad products that aren't suitable for them and then lose money. Now that's it for today's episode. In the next episode, we'll take a deeper look into how big a deal not participating in the dividends within an index really is over long periods of time in certain retirement investments. The results might be shocking to you, so stay tuned for that episode.

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Want even more ideas, tools, and resources on how to navigate through financial life? Check out all the resources on the Divorce the IRS website at divorce-the-IRS.com or the Bayob Wealth website at bayobubwealth.com and subscribe to the blog to stay up to date on issues affecting retirement income planning. Don't forget to subscribe to the podcast so you never miss an episode. Bayob Wealth and Bayabub Wealth Abroad are DBAs of Bayob Wealth LLC, a Florida registered investment advisor. This podcast is designed for general education purposes only and shouldn't be taken as legal investment or tax advice. You should seek out a qualified tax professional or licensed financial advisor to determine what is best for your personal situation.