Life Insurance vs. IRA for Retirement Saving

A 401(k) plan is an obvious place to start squirreling away retirement funds – if your employer matches a portion of your contribution. But where do you go once you’ve contributed up to the max for the match, or if your place of work doesn’t offer one to begin with?

A lot of workers continue to fund their workplace plan regardless, but you have some other options, too.

One is to contribute to an individual retirement account (IRA), which usually offers a little more flexibility. Another possible route is to buy permanent life insurance. In addition to offering a death benefit for your survivors, these policies also feature a savings component. Part of your premium goes toward your death benefit; another portion builds up your cash-value account, which grows on a tax-deferred basis. 

In certain cases, the “insurance as an investment” approach can be a wise move. But when you take a look at these products more closely, you’ll find that they usually come with higher fees and greater constraints than an IRA.

Between these two strategies, an IRA is the more straightforward way to save for retirement. You simply create an account with a brokerage firm, mutual fund company or bank, and select the investments that you’d like to make with your contributions. These can include everything from individual stocks to mutual funds and gold bullion. 

The main perk of these accounts is their tax treatment, which is similar to the 401(k)'s. With a traditional IRA, your qualified contributions – up to $6,000 in 2019 (up from $5,500 in 2018) or $7,000 total if you are 50 or older via a $1,000 catch-up contribution ($6,500 in 2018) – are tax-deductible, and the investments grow on a tax-deferred basis. In retirement, you pay ordinary income tax on whatever amount you withdraw.

A Roth IRA has similar benefits, but in reverse. You invest using after-tax dollars (so no tax deduction at that time), but you don’t pay a dime in additional taxes on the accrued funds, as long as you’ve owned the account for at least five years and have reached age 59½ before making a withdrawal. 

Permanent life insurance policies are a little more complicated. Each time you pay a premium, part of it goes toward a cash-value account. With a whole life insurance policy, the carrier credits your account by a certain percentage based on how its own investments perform. If you’ve had your policy for a few years, you’ll typically see annual returns in the 3% to 6% range. 

Other types of permanent life insurance work a little differently. For example, with a variable universal life insurance (VUL) policy, the amount of the credit is tied to the performance of stock funds and bond funds of your choosing. The potential returns are higher, but so is the risk. If the market loses ground over a given period, you may have to pay a higher premium in order to keep your coverage in place. 

Investors who rely on life insurance for retirement needs should think long-term – it can take 10 to 20 years to build up a sizable cash-value account. Once your balance is big enough, there are a few ways you can draw on your policy for personal needs.

One possibility is to make periodic withdrawals. As long you don’t pull out more than your basis – that is, how much you paid in premiums – you won’t experience a tax hit for doing so. Any additional amount is subject to ordinary income tax rates.

To keep the IRS at bay, some folks stop making withdrawals once they reach their basis. From there, they take out a loan against their policy, which is usually tax-free. 

Yet another option is to surrender your policy and get the cash-value in one lump sum, minus any outstanding loans.

But there’s an important catch: Any time you take money out, you’re decreasing the death benefit for your heirs. If you take a loan against your policy, you have to pay it back (with interest) in order to build it back up again. And if you surrender it, you’ll probably lose your coverage altogether.

Compare this to someone who buys a much cheaper term life insurance policy, which has no savings feature, and invests the difference in an IRA. They can dip into their savings at any time after age 59½ without affecting the insurance or its payout in case you die. And they can leave any remaining balance to their family members, which can’t be said of your cash-value account. 

Perhaps the biggest knock on permanent life insurance policies is their cost. First, there’s the upfront fee that helps pay the agent’s commission. Often, this can eat up half your first-year premiums. Consequently, it takes a few years for your cash-value account to really start growing.

On top of that, policyholders tend to face steep investment fees, often around 3% a year.  By contrast, the average expense ratio for all equity mutual funds offered for sale is 1.25%. So investing in an IRA allows you to eliminate this significant drag on your returns.

But that’s not all. You also have to worry about surrender charges if your policy lapses within the first few years. So you’ll not only lose your death benefit, but a considerable portion of your cash balance as well.  With most policies, the amount of this fee gradually decreases over a period of years and then disappears.

Does it ever make sense, then, to use life insurance as an investment? Absolutely, in some limited cases. For example, wealthier individuals will sometimes set up what’s known as an irrevocable life insurance trust so their heirs can avoid estate taxes. Technically, the trust is paying the premiums for the life insurance policy, so the death benefit isn’t considered part of the deceased family member’s estate.

Beyond that, life insurance is sometimes a reasonable choice for everyday investors who have maxed out their allowable 401(k) and IRA contributions. But even then, it’s worth evaluating whether the sizable fees outweigh the potential tax benefits.  

Agents make a lot of money selling the idea that life insurance is a great way to save for retirement. But given the considerable cost of these policies, you’re probably better off purchasing a low-cost term policy and investing in something simpler, like an IRA.