IRA Vs. Life Insurance: Which Is Best For Retirement Saving?

Morsa Images/Getty Images

You have several options when it comes to saving for retirement. An employer-sponsored plan such as a 401(k) or 403(b) is usually the best place to start, especially if they offer an employer match. But after that, you may consider contributing to an individual retirement account (IRA) or even use a life insurance policy as a way to save for your golden years.

Here’s what to know about the differences between an IRA and life insurance and what to watch out for if you decide to purchase a life insurance policy.

IRA vs. life insurance

Both an IRA and permanent life insurance let you build up savings over time. With an IRA, your balance depends on how much you contribute. With permanent life insurance, your balance depends on the policy you get and the way your policy is invested. While both can be used for retirement savings, here are some nuances to be aware of.

Pros and cons of IRAs

If you’re not sure whether to use life insurance for retirement savings versus an IRA, here are some pros and cons to consider.

Pros

• You can choose how much you want to contribute each year, up to the limit set by the IRS.
• You can choose your own investments and decide how much risk you want to take on.
• There are typically low fees.

Cons

• You’re limited in how much you can contribute each year.
• You have to choose investments, which you may not be comfortable doing.
• There are penalties for taking withdrawals before age 59½.
• At age 73 or later, depending on your year of birth, you must take required minimum distributions.

Pros and cons of life insurance

Pros

• Depending on the policy, you can build in guarantees to protect your premiums, such as a minimum guaranteed crediting rate to protect against market downturns on indexed universal life insurance.
• You get flexibility about when to use your cash value, if at all, once it accumulates.
• The cash value is typically tax-free if it’s less than your cost basis.

Cons

• Permanent life insurance can be very expensive, costing you a lot more than the relatively minor fees you typically pay in an IRA.
• If you can’t keep up with premiums or aren’t vigilant about monitoring the compounding interest on a loan, you risk having your policy lapse.
• If you use your cash value as retirement savings, you may not have much of a death benefit to leave behind for your loved ones.

Life insurance as a retirement savings tool

Most people probably think of life insurance as being a tool to protect your loved ones in the event of an unexpected death. Life insurance helps people manage that risk effectively, but it can also be used in other ways.

Permanent life insurance pays a death benefit to the policy’s beneficiaries, but also comes with a cash value component, which can build over time on a tax-deferred basis. This cash value can be borrowed against or withdrawn tax-free as long as the amount doesn’t exceed what you’ve paid in premiums and the policy remains in place.

However, life insurance policies can be complex and expensive. High upfront fees go toward the agent’s commission and investment fees can also be high. It can take at least a decade for the cash value to build up in an account, according to Anh Le, a CPA and licensed life insurance agent in San Diego. Cashing out early will likely result in surrender charges that vary by provider, but that could run about 10 percent early on in the life of the policy.

Le says the right policy will depend on a person’s individual circumstances, but certain features can be extremely beneficial such as living benefits and guaranteed lifetime income. Policy features will vary by provider and a good agent is needed to explain the costs and policy details.

Life insurance as an investment: When does it make sense?

For the vast majority of investors, it will make the most sense to start with tools designed specifically for retirement saving, such as a 401(k) or IRA. But wealthy investors may find that they maximize those saving methods and aren’t able to contribute to Roth IRAs because of income restrictions. That’s where Le says life insurance can play a role.

Life insurance can give wealthy investors a way to build tax-free income that they aren’t able to create through the use of a Roth IRA. Life insurance policies don’t have the income restrictions or contribution limits of IRAs.

Le says young people may also benefit from life insurance policies because their premiums may be lower thanks to good health and they have a long time horizon. Life insurance generally gets more expensive as you age.

Bottom line

If you’re just getting started saving for retirement, your best option is likely to use traditional methods like 401(k) plans or IRAs to build up your portfolios. These accounts are designed specifically for retirement and are available at low costs with plenty of good investment options. Wealthy investors may benefit from using life insurance policies to create tax-free income, but be sure to understand the policy’s details and the fees you’ll be charged before signing on the dotted line.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.