04/03/09 - Life Insurance as Your Retirement Nest Egg?

By: Investor Solutions

It is in difficult economic times like these that individuals tend to get creative about how they can guarantee a steady flow of income with what little funds they may still have left.  Some people even go as far as to entertain the idea of investing or buying "products" they would have previously shunned.  Case in point: buying a whole life insurance policy and borrowing against it.  I'll make this decision easy for you - Don't go there!

During these tough times, more and more individuals are finding themselves in financial situations they never thought they would go through.  Unfortunately, for those still in the workforce, mandatory closures, bankruptcies and layoffs threaten to wreak havoc on even the most well thought out financial plan.  The situation is even worse for people already in retirement who rely on a pot of money that, due to market volatility, is rapidly dwindling.

Depending on an individual's situation, life insurance can be a very important component of a sound financial plan and there are many benefits to buying a life insurance policy.  Among these:

• Investment income earned within a policy is tax-deferred
• The proceeds from the policy can be used to protect dependents from financial ruin in case of the untimely death of the main breadwinner
• The death benefit proceeds paid to the beneficiary are exempt from federal income taxes

However, even an important and useful financial tool such as life insurance can be used to wreak financial havoc.  Although at first thought borrowing from your life insurance policy might sound like a good idea, there are many issues to consider.  Let's first take a brief look at the how the process works.

In order to be able to borrow from a life insurance policy immediately, an individual would typically buy a single premium whole life policy (assuming they don't already have a permanent policy in place).  The single premium allows the investor to have a cash value to borrow against.  It is important to note that under certain circumstances, restrictions exist where you have to have assets in the policy for the first three to 10 years before you can borrow from it.  Once a substantial amount has accumulated to borrow against and you request such a loan, the insurer will charge a stated rate of interest on the amount borrowed.  Typically, the interest rate you will get on this type of loan is less than what you would get for a mortgage, home equity line or other type of loan.  Unfortunately, there can be hidden costs that end up increasing the low stated rate of interest.

Unlike other loans such as mortgages, there is no set repayment schedule associated with borrowing against the cash value of a life insurance policy.  Although this may seem like a good thing, it can really be quite detrimental financially.  That's because the unpaid interest is added to the amount of the loan and the interest due is calculated based on that figure.  That is, loans against life insurance policies have accrued rather than simple interest.  It is also worth mentioning that when you borrow from a policy, you are not really borrowing your own money.  Rather, the insurer is giving you a loan and using your policy as the collateral.

Now that we have a basic understanding of how this scenario works, let's touch upon the downsides of such a strategy.  They include:

• If your payments on the loan are not high enough to cover the interest owed, interest will continue to accrue and be added to the loan balance.  As the balance increases, so does the interest owed.  If the loan balance exceeds the cash value, your policy could lapse.
• If the policy lapses or is terminated, the excess of cash surrender value over the principle is taxable gain.
• If you annuitize the policy (in other words, ask the insurer to pay you the cash value over time), you pay tax at the ordinary income tax rates on any profit accumulated.
• Life insurance companies sometimes project benefits based on current rates & future rates are not guaranteed.  As you would expect, future rates usually decrease and with them, your benefit amount.
• Qualifying for a policy typically requires a medical examination and if there are any health issues, the cost of obtaining a policy could be exponentially higher.
• Dying with an outstanding loan balance will reduce the death benefit to your heirs by the amount of the loan outstanding.

Borrowing from a life insurance policy should be considered only as a last resort.  Although it is comforting to know that those proceeds are potentially available to you, tapping into them should be done with a great degree of caution.  Safer alternatives, such as reducing discretionary expenses, should be exhausted before considering a loan from a life insurance policy.  When making important financial decisions such as this, contact your financial or tax advisor who can help give you insight as to the consequences and alternatives.

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