An insured retirement plan (IRP) is a strategy used to build a tax-deferred investment inside of a life insurance policy during your working years. When you retire, instead of withdrawing these funds directly from the life insurance policy, you use the policy as collateral on a loan. At retirement, you can establish an annual line of credit against the policy where the maximum loan percentage is connected to the type of investment within the policy. This strategy and the earnings on the money within the insurance policy and the loan from this policy act as a tax shelter for the investor.
Primary Components of an Insured Retirement Plan
There are three main elements to the insured retirement plan:
Life insurance: Life insurance is protection for loved ones or business interests after you pass. For permanent coverage with the insured retirement plan, there are two parts: insurance coverage and cash value.
Accumulation: Your cash value investments grow tax-deferred with some restrictions. How much you’re capable of growing depends on the purchased policy.
Income: You can access your assets by withdrawing cash, getting a policy loan from the insurance company or using the cash value of the policy as collateral to obtain a loan from a bank or trust company.
Tax-Exempt Life Insurance
First and foremost, you must be considered insurable to apply and purchase a life insurance policy. Your life insurance contract must meet the IRS definition to receive favorable tax treatment. Section 7702 of the U.S. Tax Code differentiates between a genuine insurance plan and a vehicle used for investment.
You can contribute to your life insurance policy up to your contract’s maximum amount to qualify for a tax exception. Once you’ve left your policy to grow for at least ten years, you can access funds. As discussed above, payments using cash value as collateral are non-taxable while withdrawals and policy loans could be taxed.
How the Loan Works
Your loan can be structured in different ways. The interest on the outstanding amount can be capitalized, meaning it is payable upon your death or you can make regular interest payments.
Upon death, the life insurance policy pays off the loan, including the principal and interest, and the remaining proceeds are distributed to beneficiaries. If withdrawals are made prior to death, the bank will receive its cash values, and the proceeds you receive from the policy will be taxed as ordinary income.
The amount you will be allowed to borrow from financial institutions depends on the cash value of the policy and will be based on a percentage ranging from 50% to 90%. The loan rate is not connected to the growth within the policy, and the financial institution will closely monitor the loan to cash value ratio.
While term life insurance policies are considered standard to protect loved ones and business interests upon death, an insured retirement plan can be more proactive. Benefits paid upon death through an insured retirement plan aren’t permitted to exceed the cash value of the policy through the loan. It’s also important to keep in mind that if interest rates should rise and the borrower isn’t paying total annual interest, the lender may require additional collateral or to pay down the loan. By working with a financial advisor, you can get better clarity on the benefits and drawbacks of an insured retirement plan and make the most out of this strategy.
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