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Life Insurance as an Alternative to a Non-deductible IRA – Reason #1: Replacing the Post-Retirement Income Gap

 

The coming tax season is a perfect time to help your high-income clients assess the options available for their additional savings.

In a series of 6 back-to-back blog posts, we illustrate 5 key reasons why cash value life insurance can be a powerful savings vehicle when compared to other retirement income sources, especially a non-deductible IRA:

  1. Replacing the Post-Retirement Income Gap
  2. Diversifying Taxes at Retirement
  3. Cushioning a Market Downturn
  4. Guarding Longevity
  5. Maximizing Social Security

Today we flesh out Reason #1.

Ten thousand people are turning age 65 every day in America:

The Baby Boom Generation is the first generation who will retire with self-directed retirement savings. While some will have conventional pensions, many will rely only on Social Security and their personal savings to fund their retirement. 1  It’s even more important than ever for clients to know ALL their options to save for retirement.

1YouGov Omnibus 2017

Clients with relatively high incomes will feel especially vulnerable at retirement given the potentially wide income gap they may experience due to limitations on contributions to an employer-sponsored retirement plan like a 401(k) or 403(b).  The gap between pre- and post-retirement income for high income earners is likely to be vast.

Take a look at the replacement ratio of annual compensation pre-retirement based on income level just before retirement, what they can potentially contribute to their employer-sponsored plan and what they might expect to get from Social Security in the best-case scenario:

REPLACEMENT OF ANNUAL COMPENSATION WITH SOCIAL SECURITY & 401(K) INCOME SOURCES AT RETIREMENT
CURRENT AGE 45 MALE
Compensation $50,000 $100,000 $200,000 $300,000 $400,000
401(k) Plan Contribution (10% of Compensation) $5,000 $10,000 $19,000 $19,000 19,000
401(k) Annual Benefits @Age 67 $18,054 $36,108 $68,605 $68,605 $68,605
Social Security Benefits beginning @Age 67 $22,513 $33,295 $38,340 $38,340 $38,340
Total Annual Retirement Income beginning @Age 67 $40,567 $69,403 $106,945 $106,945 $106,945
GAP ($9,433) ($30,597) ($93,055) ($193,055) ($293,055)
Replacement Ratio % of Compensation Replaced by Social Security & 401(k) 81.1% 69.4% 53.5% 35.6% 26.7%
Retirement GAP for upper income clients
Benefits from the 401(k) assume age 45 male makes maximum contributions allowable to 401(k) annually for 22 years, until age 66, and then purchases a single life annuity at age 67. Social Security Benefits are projected based on the Quick benefits calculator at ssa.gov.

Sometimes stuffing more savings into a non-deductible IRA sounds like a good idea for high-income earners who have reached their contribution limit on their 401(k) plan. That’s one option. However, there are contribution limits with a non-deductible IRA as well; In 2019 that’s $6,000, with a $1,000 catch-up for individuals age 50 or older. What’s more, the taxable portion of withdrawals from these IRAs taken before age 59 ½ may be subject to a 10% penalty.

Since a non-deductible IRA has tax attributes that are similar to cash value life insurance, it may make sense for clients to consider their life insurance and retirement needs at the same time. That is, unlike the non-deductible IRA, the life insurance provides life insurance during the working years to protect income for survivors. It also does not have contribution limits or penalties, other than limitations on the amount of life insurance that can be purchased or underwritten. Finally, certain cash value policies are not subject to market volatility, or can be designed with guarantees that minimize that risk.

How Life Insurance Can Help to Fill the Retirement Gap

One way to address the retirement income gap for high earners is to look at their life insurance needs for their family. It may be possible to plan their insurance needs today around their retirement needs tomorrow. For example, assume John Doe, age 45 has a family and requires approximately $400,00 to 500,000 of death benefit today to take care of his wife and son should he pass away prematurely. He expects that he will need more coverage over the next ten years as he earns more. By purchasing a cash value policy whose death benefit grows every year, he could use the policy’s tax-favored cash values to supplement his income at retirement, when his protection needs diminish.

Let’s say he projects that he will be at $200,000 of income at retirement and that his income replacement ratio is 53.5% as indicated in the chart above. To make up a portion of the remaining 46.5% he could design the hypothetical cash value life insurance policy so that it fills in the gap. Life insurance distributions, if structured properly, can be structured as part withdrawals and part loans, allowing John to avoid income taxes on the distributions. This means that the amount John actually needs to replace is less since he does not need to pay income taxes. What’s more, this hypothetical policy is not subject to market risk.

FILLING THE RETIREMENT INCOME GAP WITH CASH VALUE LIFE INSURANCE AS A TAX-ADVANTAGED INCOME SUPPLEMENT
MALE, AGE 45 PREFERRED NON-TOBACCO
Pre-retirement Income to replace Post-retirement income from 401(k) & Social Security @ age 67 Shortfall Cash Value Life Insurance designed to fill the gap. Tax-Free equivalent annual income @35% Life Insurance Initial Death Benefit
$200,000 $106,945 $93,055 $68,930 $508,771

In this case, John can purchase roughly $508,000 of death benefit coverage today. By the time he’s 65, he can use the policy to supplement his other retirement income sources on a tax-free basis, assuming distributions are structured properly. This, in turn, allows John to take out less from the policy since it comes out free of taxes. Moreover, the supplemental income generated from the cash value life insurance policy is not reportable income for purposes of calculating the Medicare Part B premium, which can be as high as $460 per month today, Social Security taxation, where applicable.

Consider the chart that compares features of various retirement savings vehicles:

GENERAL COMPARISON OF RETIREMENT INCOME SOURCES
Taxable
Investments
Qualified Plans/
Traditional IRA
ROTH
IRA
Non-
Deductible
IRA
Cash Value
Life Insurance
Non- Qualified
Deferred Annuity
Muni
Bonds
Deductible
Contributions
No No No No No No
Tax-Favored
Withdrawals
No No No
No Mandatory
Withdrawals
Mandatory
distributions
Mandatory
distributions
Tax- Deferred
Growth
No
Income Tax-
Free Death
Benefit
No No No No No No
No Tax Penalties
for Early
Withdrawals
Early withdrawal penalty Early withdrawal penalty Early withdrawal penalty Early withdrawal
penalty may apply
No Contribution Limits Contribution limits Contribution limits Contribution limits
Cost of Insurance Charges No No No No No
Market Risk Depends on product
Long-Term Care Coverage No No No No No
Non- Reportable Income No No No No No No

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Stay tuned for our next blog post…
5 Reasons Why: Life Insurance as an IRA Alternative
Reason #2:  Diversifying Taxes at Retirement

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