How many times have you heard that what you don’t know can’t hurt you? Actually, what you don’t know can hurt you – just ask any taxpayer who has tried to persuade the IRS not to hold them accountable for an error on their tax return because they didn’t realize it was an error.

Clients who don’t realize life insurance can be leveraged for tax diversification in a retirement plan may suffer negative financial impacts due to what they don’t know. Although many permanent life insurance policies can help diversify a retirement plan, innovation in index universal life (IUL) insurance has brought about the potential to provide protection, supplemental retirement income and long-term wealth accumulation, typically with no tax penalties on properly structured distributions at any age.

Clients’ money at work for them

Unlike the limited contribution levels of IRAs and 401(k) plans, there are few limits to the amount of money clients can put to work in a life insurance strategy, although cash value policies are subject to Modified Endowment Contract rules that discourage overfunding based on face amount, the insured’s age and other factors (more on that to come in a moment). Cash value life insurance also contains additional mortality charges that will increase the expense of the product, and this factor is among the reasons why a policy illustration should be consulted for more information. However, there are no income-based participation restrictions and the tax-free life insurance death benefit may help ensure the client’s objectives are achieved, even if the client dies sooner than anticipated.

A flexible IUL product, which provides a greater potential for interest than a traditional universal life policy, may fit the bill for clients seeking safety and the potential for cash value growth. That’s because, although IUL is an insurance product rather than an investment, it provides cash value growth potential through index-linked interest credits. Clients do not invest in an index directly; rather, growth potential in IUL cash values is linked to market index performance, with guaranteed floors protecting against loss in down markets. (All guarantees are backed by the claims-paying ability of the issuing insurance carrier.) Furthermore, IUL supports the power of tax diversification for clients’ retirement portfolios.

Tax treatment of retirement assets

Many people understand the benefits of diversifying investments among asset classes to manage risk and return in a retirement plan. But diversification can also be used to manage the tax treatment of retirement assets, resulting in the potential for higher net income during retirement years.

If the client’s objectives include minimizing tax exposure every year, he or she may want to allocate assets among various types of financial products/accounts where asset growth is taxed at different rates and times. It may be helpful for the client to be able to discern among assets that are taxed later, such as 401(k) accounts; mutual funds that are taxed now; and solutions such as life insurance, the cash values of which may never be taxed.

It may also be helpful to walk clients through a comparison of the features of various financial accounts/products, including life insurance policies, that may be part of an overall balanced retirement plan. Among the features that may make cash value life insurance particularly attractive are tax-deferred accumulation, an income-tax free death benefit for beneficiaries, different IRS limitations on premiums paid than on contributions to qualified plans, the potential for missed premiums to be “made up” at a later time, income-tax free distributions (when properly structured) using withdrawals and loans, and client access to cash values prior to age 59½. These features are contingent, of course, on the policy complying with IRS requirements to qualify as a life insurance contract. Additionally, total premiums in the policy cannot exceed funding limitations under IRC section 7702.

Under some circumstances, withdrawals from the contract may be treated as income first and includible in the policyholder’s income. For example, if the policy is classified as a Modified Endowment Contract (see IRC section 7702A), withdrawals or loans are subject to regular income tax to the extent there is any gain in the policy. Also, an additional 10 percent tax penalty may apply to the taxable portion of those policy distributions if they are taken prior to age 59½. Note that distributions will reduce policy values and may reduce benefits; and the availability of policy loans and withdrawals depends on multiple factors, including, but not limited to, policy terms and conditions, performance, and fees or expenses.

Nonetheless, clients may appreciate the opportunity to leverage the advantages an IUL policy provides for a tax diversification strategy of retirement assets. While a 401(k) alone has merit, it may not have enough.