In planning for retirement, most investors are familiar with the concept of diversification as a way to minimize the volatility of their portfolios over time. However, another important financial strategy is often overlooked: tax diversification. By leveraging tax diversification through the use of tax-free assets, such as life insurance retirement plans (LIRPs), investors can build long-term wealth by reducing their tax burdens now and into the future.

What is tax diversification?

Tax diversification refers to the strategy of investing in a variety of tax-advantaged accounts—including both tax-deferred and tax-free assets—as a way to minimize taxation each year. When saving for retirement, many people over-allocate to tax-deferred plans, such as traditional IRAs and 401(k)s. While these plans are integral to any comprehensive retirement savings strategy, they are also subject to losses due to market downturns. In addition, distributions are taxed at the investor’s income tax rate. Considering that tax rates are likely to rise in the coming years, many investors could face significant reductions in their retirement income due to taxation of withdrawals from these traditional plans.

Tax-free assets, on the other hand, include Roth IRAs, LIRPs, and municipal bonds. By pursuing a tax diversification strategy that includes tax-free assets, investors can safeguard themselves from tax increases, market volatility, and other factors that could negatively impact their financial comfort during retirement.

What are life insurance retirement plans (LIRPs)?

Life insurance retirement plans are long-term life insurance policies that are funded beyond standard premium payments as a way to encourage growth in the cash value of the policy, instead of merely providing death benefits. As a result, LIRPs may yield numerous advantages, including the following:

  • Life insurance retirement plans have no income limits. On the contrary, many traditional retirement plans limit or prohibit high-income earners from contributing to them. For example, married couples filing jointly may not contribute to a Roth IRA if they earn $203,000 or more in 2019, while single taxpayers are not eligible if they earn $137,000 or more. Life insurance retirement plans do not have these restrictions, making them a valuable tool for wealthier investors seeking to maximize their retirement savings.
  • There are no contribution limits, allowing greater flexibility for those who want to invest as much as possible in their retirement plans. In addition to having income limits, the IRS generally sets annual contribution limits on traditional retirement plans.
  • The cash value of the policy enjoys tax-deferred growth.
  • Distributions from the LIRP may be taken on a tax-free basis. Therefore, they do not affect the investor’s income tax bracket, capital gains exposure, or Medicare premiums. By contrast, withdrawals from traditional retirement plans are typically added to taxable income, thereby requiring additional taxation that may have a negative effect on a retiree’s financial well-being.
  • Life insurance retirement plans are contractually shielded from market volatility, making them an ideal option for anyone who is concerned about losing money in an economic downturn and would prefer steady, predictable growth.
  • Although LIRPs are intended mainly to provide tax-free retirement income, they also offer death benefit protection in the present. This allows investors to ensure financial security for their heirs when they pass away.
  • Life insurance retirement plans offer greater flexibility when it comes to taking distributions. Many traditional plans impose penalties for taking distributions before a certain age (generally, 59.5), while also mandating distributions after age 70.5. Life insurance retirement plans do not follow these rigid limitations; investors may withdraw at any time as long as the policy is in effect, allowing them to access their money when the need arises—or continue saving for as long as possible. Most LIRPs also feature flexible investing options, which usually include a choice between a market-based return on a variety of mutual funds or a fixed return guaranteed by the issuer of the policy.

Who should consider using an LIRP as a tax diversification strategy?

While LIRPs offer numerous benefits for certain investors, they may not be the right vehicle for everyone. Ideal candidates for an LIRP include:

  • High net-worth individuals who are already maxing out their contributions to traditional retirement plans. By omitting any limitations on income or contribution amounts, LIRPs may provide a valuable option for those seeking to truly maximize their retirement savings.
  • Individuals between the ages of 20 and 65 who are in relatively good health. As with any life insurance policies, the cost-effectiveness of LIRPs may vary depending on age and health status.
  • Those who understand the importance of tax diversification in retirement planning and are committed to a long-term investment strategy.

Benefit illustration: tax diversification through an LIRP

At Capital Review Group, our mission is to help business owners maximize the tax savings available to them in order to build wealth in the present and future. Among our previous clients were the owners of a successful hotel. As they approached retirement age, they wanted to boost their tax savings, increase the amount of income that would be available to them in retirement, and ensure financial security for their heirs. After helping the hotel owners save a staggering $700,000 in taxes through the IRS-approved strategy of Cost Segregation, we assisted them with the process of creating a more tax-efficient estate plan that included an LIRP. By applying their $700,000 tax savings to the LIRP, the couple would be able to enjoy an estimated tax-free benefit of over $2.2 million—an amount that would assure them financial comfort in the future while providing the hotel with enough liquidity that it would be able to stay in the family for generations. Read more about the strategies we pursued in this case:

Is tax diversification through an LIRP right for your retirement strategy? Contact the tax experts at CRG today to schedule a pro bono analysis!