Life Insurance vs. Roth IRA for Retirement Savings
- Compare life insurance vs. Roth IRA accounts for saving for your retirement. Learn about the benefits and drawbacks of both retirement account options.
The U.S. Department of Labor reports that the average American will spend 20 years in retirement and that most people will need 70% to 90% of their preretirement income to maintain their standard of living. As a result, saving money for retirement now is the key to securing your financial future. Life insurance and Roth IRA accounts can provide you income after you retire. Each option has its own benefits and drawbacks, making it important that you compare life insurance vs. Roth IRA accounts before you make an investment decision.
Life Insurance vs. Roth IRA: How They Work
A life insurance policy and a Roth IRA are fundamentally different.
Life insurance retirement plans (LIRPs) involve buying a permanent life insurance policy that pays a cash value. Often, people use whole life to fund LIRPs. As you make premium payments on your life insurance, a portion of the money is placed in a cash account that you can withdraw from in retirement.
The cash account can provide income for retirement in one of three ways.
- Overfunding the policy. You can build up the cash value more quickly by paying more than the set amount each time you make a scheduled premium payment on your life insurance policy. Strict rules govern how much you can contribute and when you can withdraw cash from the policy.
- Supplementing other retirement income. Experts typically recommend that you withdraw no more than 4% of the value from each of your retirement accounts to help preserve your savings. You can withdraw money from a life insurance cash account to supplement income as needed.
- Assisting with long-term care. Some policies offer a long-term care rider that lets you take some of the death benefit as a lump sum that can help cover the cost of care in a nursing or assisted living facility.
When you take an accelerated benefit to pay for long-term care or make a cash withdrawal, the death benefit of a life insurance policy is usually reduced, meaning your beneficiaries will get less money when you die.
A Roth IRA is a retirement account funded with compensation that you have already paid income taxes on. It differs from a traditional IRA, in which contributions are tax-deductible.
With both Roth IRAs and life insurance, you can normally take cash withdrawals after age 59.5 without having to pay a penalty provided you have had the account for:
- At least 15 years for life insurance
- At least 5 years for a Roth IRA
How money grows and distributions are treated from a tax perspective varies:
- Life insurance. Money grows tax-deferred. You normally don't have to pay income tax on withdrawals unless they exceed the base amount of the cash value. An LIRP may also be subject to capital gains tax.
- Roth IRA. Money grows tax-free, and distributions aren't taxed as income. The money is not usually subject to capital gains tax.
With a Roth IRA, you don't have to take minimum distributions each year. An LIRP may require you to make withdrawals depending on the terms of the policy and how much you have paid in premiums.
Life insurance companies may limit how much you can pay toward a life insurance policy to overfund it. Under the federal rules governing Roth IRAs, you can contribute:
- Up to $6,000 per year if you're 50 or younger
- Up to $7,000 per year if you're over 50
Some people choose to invest in both LIRPs and Roth IRAs. With this arrangement, an investor makes the maximum allowable contribution to a Roth IRA first and then contributes any remaining funds to their LIRP.
Potential for Earnings
Roth IRAs give you many investment options and generally pay a higher rate of interest than an LIRP based on a whole life insurance policy. You may earn a higher rate of interest by using variable life or some forms of universal life for an LIRP.
Generally, life insurance is a more expensive way to save for retirement. When you pay a premium on your life insurance, only a portion goes to fund the cash account. The rest covers the costs of the insurance.
With a Roth IRA, you normally pay account maintenance fees. The financial institution may also charge transaction fees and commissions when you establish your account. Still, the fees are normally less than what you must pay to maintain life insurance.
Risk of Loss
Risk exposure is an important consideration for retirement planning and another area where a life insurance policy and a Roth IRA are different.
Do You Lose Money With a Life Insurance Retirement Plan?
Whole life insurance policies don't carry financial risk. Even with policies where the interest rate varies, the cash value is guaranteed to earn a minimum amount. Some other types of permanent life insurance such as variable life and indexed universal life do open you up to financial risk because the higher interest rates that they pay are based on the performance of investments or financial indexes.
Do You Lose Money in a Roth IRA?
It's possible to lose money with a Roth IRA if:
- Economic downturns cause investments to lose value
- You take an early withdrawal and are assessed a penalty
- The life of the Roth IRA isn't long enough to allow interest to compound
Establishing a Roth IRA when you're young, making annual contributions and leaving the account untouched until retirement can greatly minimize the risk of loss.
Can I Put Life Insurance in a Roth IRA?
Tax laws only allow you to make Roth IRA contributions out of money earned through compensation, such as:
- Professional fees
- Taxable alimony
Life insurance payouts and cash withdrawals don't usually meet the definition of compensation. As a result, you usually can't take a death benefit payout from a life insurance policy and use it to establish or contribute it to an IRA. In general, you can't take money from a life insurance cash withdrawal or surrender and use it to fund an IRA.