Both Roth IRAs and cash value life insurance policies offer compelling tax benefits for the right people. Life insurance and Roth IRAs have a lot in common. They are both often used as wealth transfer tools to help facilitate an efficient transfer of assets from one generation to the next. Despite their many similarities, however, Roth IRAs and life insurance are very different and the rules that apply to one don’t always apply to the other.
Advantages of a Roth IRA – Roth IRAs are simply a type of investment account that provides tax advantages to the stocks, bonds, funds or other assets held within them. Roth IRAs give the account holder a tremendous amount of flexibility when it comes to choosing investments. Expenses in stock mutual funds and direct investment in exchange-traded funds, stocks and bonds are frequently lower than with cash value life insurance — especially in the short term. This is due to the cost of insurance itself, as well as to the commission structure of life insurance products: You don’t write the check, but if you buy a permanent life insurance contract, you will usually have less cash value than you contributed to the policy in the early years of the contract, unless you are transferring a lump sum.
Advantages of Life Insurance – Life insurance is unique among investment or savings vehicles in that the life insurance company will provide a large tax-free death benefit to the beneficiary in the event the insured dies. This is the primary reason to buy life insurance. Life insurance cash values also don’t impose a 10 percent penalty on withdrawals. You can access your cash value in a policy penalty-free, at any time, and for any reason.
Differences between a Roth IRA and Life Insurance
Life Insurance Protection – Cash-value life insurance combines an insurance policy with an investment account. This means that if you die while investing money in life insurance, your heirs will receive a sizable death benefit that will be much more than the money you paid into your account. A Roth IRA is only an investment account. If you die with this account, your heirs only receive the money you’ve invested.
Rate of Return – Investments in a Roth IRA will grow faster than the same investments in life insurance solely because in a Roth IRA you do not have to pay for that life insurance expense.
Health Exam – To qualify for life insurance, you need to pass a health exam. The insurance company might check your health records, send over a nurse to give you a physical or ask you to get a checkup with a doctor. If your health is too poor, you could get a rated, more expensive policy that would hurt your investment return. It’s possible to get denied insurance altogether. Because a Roth IRA is just an investment account, no health exam is needed to use this plan.
Contribution Restrictions – There are some restrictions on investing money into a Roth IRA. As of 2014, you can only invest up to $5,500 a year into a Roth IRA if you are younger than 50 and up to $6,500 a year if you are 50 and older. In addition, if you earn over a certain amount of income the amount of your contribution may be reduced or you may not be able to contribute at all. There are no contribution restrictions on life insurance. You can invest as much money per year as you want, and your annual income doesn’t matter.
Early Withdrawals – The investment gains in a Roth IRA are only tax-free if you take them out when you are 59 1/2 or older. If you take your gains out earlier, the IRS charges income tax plus a 10 percent penalty. With life insurance, you can take out your money through a loan whenever you want. This makes it a better choice for early retirement.
Reasons why whole life insurance is not like a Roth IRA
No Interest Free Withdrawals – The reason some people fall for this scheme is that the money in a whole life insurance policy does grow in a tax-protected manner, and when you borrow the money from the policy later in life (remember you can’t withdraw the money, because that’s taxable, so you borrow it), it comes out tax-free “just like a Roth IRA.” However, it is not interest-free. Just like when you borrow from a bank, when you borrow from an insurance policy you have to pay interest. It doesn’t seem fair, I know, but that’s the way life insurance works. You have to pay interest to borrow your own money. When you withdraw from your Roth IRA, you owe neither taxes nor interest.
Excessive Fees Lower Returns – Roth IRAs can be extremely inexpensive. There is no fee at all to open one at Vanguard. They also have no closing fees. The expense ratio for investments can be as low as 0.05% a year. Try comparing that to the typical whole life policy. The insurance policy not only has a number of “garbage fees,” The more you pay in fees, the less that goes toward the investment, and the lower your returns.
You Cannot Stop “Investing” – With a Roth IRA, if you make less in any given year or just decide you want to blow your money on a boat, you can do that. Not so with a life insurance policy. If you don’t pay the premiums, the policy will lapse. You could argue that this is a pro or con for a life insurance policy. It is a negative because you do not have flexibility that you do with other investment vehicles but it does serve as a forced savings plan which some people need.
Different Asset Protection And Estate Planning Treatment – Roth IRAs and whole life insurance may be treated very differently when it comes to asset protection and estate planning issues. Depending on the state, some or all of your Roth IRA may be protected from creditors. The same goes for the cash value in a whole life insurance policy. In some states one is protected more than the other, and vice versa in other states. In some states neither receives much protection, and in other states both are completely protected. The point is they aren’t substitutes for each other. The same goes with estate planning issues. A Roth IRA passes to heirs income tax-free but subject to any possible estate taxes. It can be “stretched” to allow for additional years of tax-free growth for heirs. The cash value of a whole life insurance policy disappears when you die, and your heirs are paid the death benefit (minus any money you borrowed out of the policy) without having to pay income or estate taxes on it. Any additional earnings on that money, of course, would be fully taxable to the heirs. The money in both a Roth IRA and whole life insurance passes to heirs outside of probate. Both have their positive aspects, but they are very different.
If you’re looking to leave a legacy to your heirs when you die, there are many tools to consider. Life insurance and Roth IRAs are but two of the many options we’ve chosen to contrast here today. In some cases, life insurance may not be available due to poor health. In other cases, such as when your beneficiaries will be in a lower bracket than you are now, there may be a greater net benefit by leaving them larger amounts of tax-deferred accounts, like IRAs instead of a smaller amount of Roth IRAs. The bottom line is that every situation is different and there’s no one-size-fits-all solution. Do your homework, seek competent advice and give yourself the best opportunity possible to achieve your goals.