Funding retirement with life insurance? Be wary

Using life insurance for tax-free retirement income? Yes, it is legal, but it is unlikely to be a good deal. In this week's Q&A I explain the basics of this questionable approach.
Q. I have been retired since Jan. 2008, in part due to a disability. We were thinking of putting some of our cash in one- or two-year CDs that would pay 1.25% and 1.60% respectively. I would keep my mortgage (2.65%) and deduct the interest that I will be paying, if it’s more together with my property taxes and sales tax than my standard deduction. I also read that you could buy a life insurance policy and retrieve/withdraw money from it without paying taxes and also get loans. How does that work? What would you advise? Thanks—RG

A. Thanks for writing in.
I'll start with the last question about life insurance. It is most likely not going to work anywhere near as well as the insurance company write-ups suggest. Your disability may disqualify you anyway, but stay away. Don't let them put it on your wife even if she is in great health. The insurance is what can make things tax-free, but the insurance itself is not cheap. In many cases, using insurance like this can actually result in a huge tax bill.

A life-insurance policy can be used to accumulate money tax-deferred. When you want to get cash out you can surrender to your basis (basically the sum of your premiums), then switch to loans to continue the cash flow. All of these withdrawals will be tax-free. Upon death, your heirs will get a death benefit.
Unfortunately, while the concept is appealing, it falls apart due to costs. The insurance company wants to have a good handle on your health before agreeing to insure you. A good chunk of your premiums will go to cover the costs of underwriting the policy and not into the cash pool.
The people that sell the policy to you need to get paid. That also comes from your premiums and is factored into the ongoing costs billed against the cash values. To assure the company recoups what it pays for sales, most policies impose surrender charges in case you bail out on the arrangement too early for them to collect enough ongoing fees.
On an annual basis, there is a risk that you could die, so the cost of the insurance is charged against the cash. The worse your health issues, the more the insurance costs. Further, as you age, the cost per thousand of the amount at risk to the insurance company goes up. The older you get, the faster those rates increase. The amount at risk is the difference between your cash value and the death benefit.
The cash is earning interest or, in a variable contract, can be invested in what are essentially mutual funds, none of which are free. When the investments do poorly, the amount at risk increases, causing the charges against the cash to increase. In variable contracts, premium taxes can apply too, further reducing the cash pool.
Once you are in one of these, you are stuck with the provisions of the contract. One issue is that you can't tell what the cost of the insurance is going to be at any point in time. The company can change the per thousand rate subject to certain caps. Even without the cap, the rate per thousand tends to be higher than comparable term policies.
Once you tally what you put in against what you get out in projected cash flow, net of costs, the bottom line is not attractive compared with other investments.
The huge tax bill comes after one gets into the loan stage. In addition to the ongoing and increasingly expensive cost of insurance, many contracts allow you to pay the interest from the cash value that was not surrendered as basis rather than writing a check. In a variable contract the cash value can decline due to the markets. As a result, the loan balance rises as the cash value drops at an accelerating rate.
The tax bill hits when the cash value goes to zero. The policy “lapses” at that time and you get to pay ordinary income taxes on the full outstanding loan balance. If the size of the pending 1099 doesn't induce a fatal heart attack before the policy lapses, you have to pour cash into the policy to keep it afloat (more for the “what you put in” part of the evaluation).
Just as these numbers can work against you, they can be manipulated so that the policy won't lapse, but this means more going in and/or less coming out, making it less attractive.
Life insurance is an important part of most family's financial planning, but start simple and cheap with basic term insurance to replace lost income upon an early death. There are simpler, easier, far cheaper, and more flexible ways to manage taxes on your savings than using an insurance policy.
On the mortgage, to oversimplify the issues, your comments about the standard deduction imply to me that your after-tax cost of borrowing may not be much less than 2.65%. Your after-tax earning will be less than the 1.25% and 1.6% from the CDs by whatever your marginal tax rate is. From a purely mathematical standpoint, not paying close to 2.65% is better than earning less than 1.6%. That is probably pretty appealing given your conservatism.
However, when the CDs come due, you will get your cash without much hassle. To get to those funds after you put them toward the mortgage, you must either borrow against the home or sell the property. Either can be a hassle. That's probably not so appealing. It's a classic trade-off.

Dan Moisand's comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you.

source  marketwatch