Creating Flexible Retirement Strategies With VUL

by Shawn Britt

Previous generations expected to retire for good at 65. But today’s clients have a different mentality. People are living longer and healthier lives and they have more choices to customize their retirement.
Clients who are approaching retirement may raise some of the following questions:

•I’m thinking about retiring early; how can I fund my initial retirement years in a tax efficient manner?
• I’ve thought about phasing into retirement, but could it result in high taxation of Social Security benefits?
• What if I live too long? I’m concerned that inflation or depletion of assets could eat into my retirement lifestyle.

Variable universal life insurance is one solution that can provide protection for the family during the breadwinner’s productive years and serve as an investment vehicle, creating flexible solutions for supplemental retirement needs.

What is Income Layering?

Income layering allows a client to determine which assets to use first when beginning retirement. Different retirement vehicles are used to create tax-deferred growth potential. The client can tap into assets in a tax-efficient manner as retirement progresses.

While qualified assets are important in retirement planning, they are subject to age restrictions, contribution limits, taxation, and required minimum distributions. A life insurance policy is generally free of these restrictions as long as it is not a modified endowment contract (MEC) and it remains in force. As part of a layering strategy, a VUL may provide tax-free income without penalty to clients who want to do the following:

• Retire before 59½.
• Use it as interim income to delay Social Security.
• Use it to fight inflation or replace depleted assets if retirement goes on longer than expected due to longevity.

With its flexible structure, tax-free withdrawals and loans, and no pre-59½ penalties, VUL may allow flexibility whether your client has a definitive plan or is still determining when and how to retire.
Cash value in a life insurance contract accrues tax-deferred under the Internal Revenue Code (IRC). Income from a cash value life insurance contract can be accessed income tax-free in most situations. This assumes that the contract qualifies as life insurance under IRC Section 7702. Most distributions are taxed on a first in/first out basis as long as the contract meets the definition of a non-modified endowment contract under IRC Section 7702A.

Surrender charges may apply to partial surrenders. Loans and partial surrenders from a MEC are generally taxable. They may be subject to a 10% tax penalty if taken before 59½. Loans and partial surrenders would reduce any payable death benefits. The loan amount in excess of basis would be treated as a distribution if your contract lapsed with a loan outstanding. All or a portion would be subject to income tax.

When Your Client Needs Supplemental Retirement Income

Highly compensated employees who max out their qualified plans often look for additional tax-deferred investment vehicles. Because of their high salary, they don’t qualify for the tax deductibility of a traditional IRA or qualify to make contributions to a Roth IRA. They face another dilemma. The higher their salary is, the harder it is to invest through qualified plans and Social Security for income replacement in retirement.

One answer is to use variable universal life insurance (VUL) in an “insurance based retirement plan.” Most importantly, VUL is for a client with a life insurance need. VUL may be appropriate for a client with the following characteristics:

• Can have the money invested for at least 15 to 20 years.
• Has an acceptable risk tolerance and understands the market volatility of sub-account investments.
• Wants an insurance product that can accumulate cash value in a tax-deferred manner.
• Wants some flexibility in making premium payments.
• Wants a product that allows investing in a tax-preferred manner.
• Does not want the limitations of ERISA-based contributions.
• May want to take withdrawals before age 59 ½ (assuming non-MEC status).
• Wants income benefits that can be taken on an income tax-advantaged basis.

A key thing to remember with an insurance-based retirement plan is that beneficiaries get the death benefit income tax-free upon the death of the insured. It’s important to note that estate tax may apply.

The Retirement Myth

There is a misconception that a person’s income tax bracket will be lower in retirement because the available income is reduced to some degree. That is not always the case. The retiree may have fewer tax deductions when the home is paid off or is close to being paid off; the children may be grown; or the retiree may have benefited from successful investing. People who are trying to keep their tax bracket stabilized may find a tax-efficient way to provide living expenses by taking withdrawals and loans from their life insurance policy. This income tax-free source of funds would not affect their tax bracket. This can be particularly true for someone phasing into retirement and still collecting a salary.

Early Retirement

Tax-efficient income strategies can make sense for a client who wants to retire before 59 ½. It would carry them until qualified investments are available without penalty. The 72(t) distributions may not offer the best solution even though they are available without penalty. Your client may profit by waiting to tap into these assets if the qualified plan or IRA is funded with annuities with guaranteed minimum withdrawal benefits (GMWB).

Many GMWB riders pay a higher percentage of guaranteed income if the client waits until they are older to start the income benefits. Taking the income at a younger age could be counter-productive. They could end up locking in a lower guaranteed percentage on which to base the benefit amount. That amount would be fully taxable until cost basis becomes part of the payment.
One solution to the income gap is to take tax-free withdrawals and loans from a life insurance policy until reaching 59½. Gross income and net income would be the same since withdrawals to basis and loans are paid income tax free (assuming the policy is a non-MEC). With no taxes to consider, the client could withdraw a smaller amount of funds to meet income needs. The client could begin taking income from qualified assets after reaching age 59½.

Phasing Into Retirement

Another option is to phase into retirement. Unlike most of our parents who expected to retire at 65, many people are immersed in careers that they don’t want to leave just as they start enjoying the fruits of all their labor. When it comes to Social Security, phasing into retirement can be expensive. As much as 85% of your client’s Social Security benefit could be subject to income tax if they continue earning income after getting Social Security benefits. Delaying Social Security benefits until 70 can pay off if your client is healthy, especially if they continue to work even part time. For instance, a person who turns 62 in 2009 would get $17,316 a year in benefits based on a $93,000 income. By waiting until 70, the benefit would be $35,580 a year in today’s dollars. At about age 77, the retiree would break even when it comes to cumulative payments received. From that point on, the retiree is far ahead in annual and cumulative benefits. The break-even age may be attainable for a healthy person. The break-even point can come even sooner if the retiree continues to earn income and heavy taxation of Social Security benefits is considered. This makes delaying benefits more attractive.
Your client may want some income in those semi-retirement years to replace Social Security benefits. Taking income from a VUL is a viable way to supplement other sources of income. Plus, that income would not be taxed regardless of how much other income your client brings in, which helps control income tax brackets.

Retiring with Tradition

Your client may want to retire in the traditional fashion at age 62, 65, 66, or 67, but may be concerned about living so long that inflation or income depletion could eat into their lifestyle. A recent study from the Social Security Admin. reveals that, if both spouses are still alive at age 65, one has a 50% chance of living to age 92. To deal with this issue, your client could take income from the life contract long after retiring. This income stream would replace income sources that have ended or no longer supply enough income to maintain a desired style of living.

Conclusion

As financial professionals, you may want to discuss these options and others with your clients. An insurance-based retirement plan to cover the life insurance needs and invest additional penalty-free and tax-free dollars for retirement can meet your clients’ objectives. It can also offer flexible solutions for those who have yet to decide on final retirement goals.

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Shawn A. Britt serves as an advanced sales consultant for Nationwide Financial in Columbus, Ohio. She may be reached at britts@nationwide.com.