How does a tax-free retirement plan really work?

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Tax-Free Retirement Living

Tax-free retirement plans are frequently misunderstood by advisors and clients alike. From tax-free growth to tax-free retirement distributions, this plan is often the missing piece of the retirement planning puzzle. Let’s see how it works..

Imagine a retirement solution that offers tax-free growth on your investment while also allowing you to take out funds tax-free, without disturbing your income generating account. Sound too good to be true?

It’s not! That’s the essence of our tax-free life insurance retirement plan. Here’s how it works.

What is a tax-free life insurance retirement plan? 

A tax-free life insurance retirement plan (LIRP) is made possible by specially crafting a particular type of indexed universal life insurance policy funded with after-tax dollars. Funds benefit from tax-free growth at a rate tied to one or more indexes. Some companies even offer bonuses on top of the index performance. A number of indexed accounts with bonuses have averaged as high as 9% over the last 20 years. After policy charges are deducted, the interest is credited to the balance of the gross account value. The policyholder can also withdraw tax-free retirement loans. But this plan funds more than one’s retirement — it also includes a tax-free death benefit that’s paid to the policyholder’s family after they pass.

How do tax-free retirement distributions work?

 Specific types of policy loans allow a policyholder to collect tax-free retirement distributions without disturbing the gross accumulation account, which generates earnings. It’s easy to mistakenly assume that this loan is coming out of their policy funds, but it’s not. The money is borrowed from the life insurance company, which uses the policy’s cash value as the collateral for the loan.

Policyholders collect tax-free distributions, while the loan interest is added to the loan. These loans reduce the net cash value and death benefit, but the gross accumulation value remains fully intact and continues to grow based on the index. That means over time, the index credits, bonuses, and available rider credits may substantially exceed the policy loans.

The tax-free distributions can be used however the policyholder chooses, whether that’s for personal spending or to invest back into the policy where it’s earning higher rates tax-free.

Here’s an example of how the second scenario plays out: Say you have $100 in your policy and take out a $25 policy loan. Remember, you still have the full $100 in your account, and $25 is collateralizing the loan. You’re accruing interest on the borrowed $25 is at the low loan rate, but you put that back into your policy, so now you’ve got $125 growing at the higher (on average) interest crediting rate.

Why choose this plan over other investment strategies?

When a person invests in the market, the frictional cost is the taxes paid on the funds — money that the investor and their family will never see again. The frictional cost of investing through an insurance policy is policy charges, but the family is recompensed in the form of a death benefit after the benefactor’s passing. With this plan the money stays in the family, working both for the policyholder and their loved ones.

Additional advantages include:

  • Premium savings through shorter premium durations
  • Flexibility to adjust premiums and generate tax-free income
  • Annual “lock-in” of earnings
  • Protection against market losses
  • Generally greater retirement distributions over time
  • No bank loans — you own your cash, not a bank

What’s in it for the insurance company?

Insurance companies are focused on their long-term general account investments, and often the best they can expect is to make 3% to 4%. With a policy loan generating interest at 4% to 5%, the insurance company is earning more and rests easy knowing it’s backed by the money invested by the policyholder at the start. It’s a win for the insurance company and a win for the client, with both sides walking away with more from the transaction than other investment avenues would offer.

Case in point: Tax-free retirement in action  

Meet Richard, a 55-year-old executive who lives in Atlanta with his wife, Mary. With his kids off to college, Richard is buckling down on the gaps in his retirement planning and he’s all ears when his trusted advisor tells him about a tax-free life insurance plan that’s perfect for him.

Richard starts contributing to his plan right away, paying in $60K for the next 10 years while he’s still working full time. On his 66th birthday Richard’s payments go down to $30K, which he pays for the next five years as he eases into retirement. Just like that, Richard turns 70 and makes his last payment, and he and Mary jet out for the African safari they’ve always dreamed about. At 74 Richard collects his first distribution of $100K and finally buys that boat. Over the next five years Richard collects more than $500K in distributions and he establishes college funds for his four grandchildren.

Richard’s health takes a turn shortly after his 80th birthday. Thank goodness for his tax-free retirement plan, because it allows him to afford the in-home care services he needs — giving him and Mary invaluable autonomy later in life and saving their kids from the burden of Richard’s care.

After a full and well-planned life, Richard passes away in his early nineties. Richard’s tax-free retirement plan served him well: after collecting over $2M in distributions over the course of his policy, he was still able to leave behind a sizable death benefit of over $500K to protect his loved ones into the future.

Whether you’re looking for a personal plan or you are an advisor seeking optimized solutions for your clients, schedule a call with a member of our team today.