Planning your financial future requires careful evaluation of investments and projecting your living expenses during retirement.
Depending on whether you have access to a pension, Social Security, and other income, investments in a 401(k) may not be enough. For better retirement planning and to max out annual contribution limits, many will choose a Traditional or Roth IRA to supplement retirement income.
Still, you may be looking for another option if you’ve already reached IRS contribution limits or if your estate exceeds tax-free inheritance thresholds. In this case, a permanent life insurance policy can double as both retirement security and an essential estate planning tool.
If you’re considering cashing out your IRA to buy a permanent life insurance policy, you’ve come to the right place. We will look at the tax implications of this financial move, examine the benefits of life insurance, and explain the inner workings of this unique tax-free savings vehicle.
Can you Transfer an IRA to Life Insurance?
You can repurpose all or some Traditional IRA funds – cash-out required – to pay for a life insurance policy. But buying life insurance with IRA money isn’t a good fit for every investor.
Because this transfer isn’t a qualified “roll-over” or tax-free exchange, you’re required to pay income tax on the withdrawal. And unless you’re receiving early-withdrawal IRA funds as substantially equal annual payments under IRS Rule 72(t), you face a 10% penalty if you’re not yet over age 59 ½.
You should analyze the potential tax implications and consult a qualified advisor to prepare for the long-term investment of a permanent life insurance policy.
In the short term, you’d likely be responsible for a large tax bill and you’d need to pay regular premiums for the new life insurance policy to remain active.
Potential pitfalls of taking IRA funds for life insurance include:
- Over-funding and triggering a Modified Endowment Contract
- Investment risks associated with mutual fund assets
- Lowering the death benefit if you take a loan later
- Waiting longer for an indexed policy to realize gains
What is Permanent Life Insurance?
Whereas term life insurance only pays a beneficiary if the insured person dies while the policy is active, permanent policies carry cash value and can provide additional flexibility in your retirement years. These policies are categorized as whole life insurance, universal life insurance, variable life insurance, or indexed life insurance. (Note, final expense insurance – a type of modified whole life insurance – remains in effect until death but typically offers a minimal face value which limits saving and borrowing power in retirement.)
Permanent policies provide a death benefit payment. This allows for a payout to your family no matter how long you live – in contrast to term life insurance which becomes an inefficient way of covering end-of-life expenses after a certain age.
Other key benefits of permanent life insurance include:
- Access to cash or a loan against the death benefit value.
- Use of the cash value to pay for long-term care services.
- Dividends or premium refunds to collect or re-invest.
- Premium pauses if you become disabled.
- A tax-free inheritance for your family.
- No required minimum annual distribution in retirement.
- Control of how beneficiaries use death benefit funds.
Life Insurance vs Roth IRA
If you have a Roth IRA and are looking to build cash value in a permanent life insurance policy, you may be able to withdraw investments without an upfront tax bill.
At any age, you’re allowed to withdraw all or part of the direct contributions you’ve made to your Roth IRA – without taxes or penalty. However, there are different rules for withdrawing Roth IRA investment earnings.
Generally, you’ll face income tax and a 10% penalty if you take cash from your Roth IRA investment earnings before age 59 ½, or if you have held the account for less than five years.
Still, taking funds from your Roth IRA to invest in a life insurance policy can protect a future inheritance. Permanent life insurance can be placed in an irrevocable trust, sheltering the funds from state and federal estate tax. By contrast, Roth IRA funds are taxable past a certain threshold when paid as inheritance. Plus, using a trust enables more control of how your beneficiaries use future funds.
Another key difference in Roth IRA vs life insurance takes into account your modified adjusted gross income (MAGI). The IRS’ 2024 rules state you can only contribute to a Roth IRA if your MAGI is less than $161,000 (single filer) or $240,000 (married filing jointly).
There is no IRS income ceiling for buying permanent life insurance.
Converting an IRA, Roth IRA, or 401(k) to Life Insurance
Since the 1980s, Americans have used 401(k)s as a primary retirement savings tool. It allows pre-tax paycheck contributions – and often employer matches – to fund investment accounts aimed at building wealth for retirement. Americans are more likely to have a 401(k) – or its tax-exempt organization counterpart 403(b) – than any other type of retirement savings account.
An Individual Retirement Arrangement (IRA) is the next common investment type — and it carries tax benefits similar to a 401(k). While a 401(k) is an employer-sponsored plan an IRA enables employee-directed retirement planning through an individual account. A traditional IRA can be funded with automatic paycheck deductions or claimed as an income deduction on your annual tax return (if not using a pre-tax payroll program).
Distributions from Traditional IRAs and 401(k)s are taxed. Both also carry penalties if you bypass the required minimum distributions starting at age 73. Roth IRAs have no minimum distribution rule in retirement and qualified withdrawals are not taxed.
Each type of retirement investment account (and related options like a Roth 401(k) or a SEP IRA) will carry a specific maximum that you’re legally allowed to put into the plan each year. Each has specific benefits and rules around eligibility and withdrawals.
Always consult with a financial advisor on specific investment strategies.
Can I Transfer my 401(k) to a Life Insurance Policy?
If you’re divesting from a traditional 401(k) or IRA – or any other pre-tax investment – to buy a permanent life insurance policy, your withdrawals will be subject to tax. Your tax bracket, your age, and the value of your 401(k) or IRA will affect how much tax you’ll pay in the year of the conversion.
Converting a Roth IRA or another after-tax investment account to purchase permanent life insurance generally presents less upfront tax liability than cashing out pre-tax investments.
You and your financial advisor should take taxes into account when structuring insurance premiums and the value of the policy.
Can IRA Funds be Invested in Life Insurance?
IRA accounts cannot hold life insurance investments nor can life insurance benefits be rolled into an IRA.
A 401(k) on the other hand may be invested in a life insurance contract. There are maximum percentages of total investment to follow if you are buying life insurance via a defined contribution plan. You face needing to move the insurance policy when you retire, if your 401(k) plan is terminated, or if you separate under an employer-sponsored plan.
Modified Endowment Contract Tax Implications
Regardless of where the funds originate, beware of letting your permanent life insurance accumulate cash value above the policy’s death benefit.
The IRS may scrutinize your new life insurance policy due to the inherent tax benefits, including tax-free loans in retirement and tax-free death benefits. The government could decide to eliminate some of the tax advantages of your life insurance policy if the IRS deems you have over-funded with premium investments. In this case, the IRS would treat the policy like a Modified Endowment Contract (MEC), which means you’ll pay taxes on any loans or withdrawals – and be subject to early withdrawal rules.
Your advisor or the policy owner should alert you if the cash value is at risk of tipping the scale toward a MEC. As the policyholder, you may choose to purchase additional death benefit add-ons to avoid a MEC.
This particular dimension of permanent life insurance illustrates the necessity of finding a professional, trusted source for your estate planning. At Independent Insurance Associates, we’ll spend time understanding your family and business goals, and offer you a variety of strategic and prosperous recommendations for life insurance. Gain peace of mind around retirement and estate planning – give us a call today!