Life insurance agents often promote permanent life insurance that accumulates cash value as a way to save for the future. For retirement planning purposes, however, such policies usually make sense only for individuals with a net worth of at least $11.7 million, the threshold (as of 2021) at which federal estate taxes kick in after death.
For almost everyone else, the best way to incorporate life insurance into retirement planning is to buy a simple term life policy with an adequate death benefit and invest any other disposable income in tax-advantaged retirement accounts.
- If you need life insurance, a term life policy will give you the most value for your money.
- By buying term rather than permanent insurance, you'll have more money to invest for retirement.
- You may also want to create an emergency fund and buy disability insurance to protect your income.
Step 1: Buy Term Insurance
Except perhaps for the independently wealthy, anyone who has children or other dependents who rely on their income for support needs life insurance. That's also true for so-called "nonworking" spouses—stay-at-home parents or homemakers, for example.
“For the working spouse, you want to have enough insurance to cover large debts (such as a mortgage), future obligations that can no longer be funded by the earnings of the deceased (such as costs for college or retirement), and living expenses for the family," says Kristi Sullivan, CFP, of Sullivan Financial Planning, in Denver.
"The nonworking spouse needs to be insured to cover the cost of child care and other household-management work that the surviving breadwinner will now have to pay for,” she adds.
The least expensive type of life insurance, considering not just out-of-pocket costs but also the amount of coverage you get for the money, is term life (sometimes called "pure life insurance"). It guarantees payment of a stated death benefit during a specified term—such as 10, 20, or 30 years—but has no cash value component. When the term expires, the policyholder can either renew for another term, convert to permanent coverage, or allow the policy to terminate.
Life insurance prices vary depending on a person's age, health, and other factors. For example, a nonsmoking 35-year-old man in good health might be able to get a 20-year term policy with a $1 million death benefit for $1,030 or so per year. If the same man bought a whole life policy, a type of permanent life insurance, the premium might be $13,500 or more annually for the same death benefit.
Given these costs, term life insurance can be a useful retirement savings tool in two ways. First, it provides the basic financial protection a family will need if one of the breadwinners dies before accumulating enough savings for the family to live on. Second, the relatively low price frees up more disposable income to use for other purposes.
“Given the lower premiums associated with the policy, investors will have more to invest for retirement, college, or other financial goals," says Mark Hebner, founder and president of Index Fund Advisors in Irvine, California, and author of Index Funds: The 12-Step Recovery Program for Active Investors.
How long a term the policyholder needs depends on how many years into the future others are likely to be dependent on them. When their kids are grown up and financially independent, they may no longer need life insurance or as much of it.
How much life insurance they should buy depends on how much replacement income their family will need and for how many years they will need it. Major debts such as a mortgage and expensive future obligations such as college tuition should also figure into the equation.
Many people get some amount of term life insurance as an employee benefit where they work. However, that isn't always sufficient for a family, so the employee might need to supplement it by buying an individual policy.
Step 2: Create an Emergency Fund
The first way to put the savings from term life insurance to work is by building an emergency fund equal to three to six months of living expenses. Having an emergency fund to cover any big, unexpected bills that come along can allow you to keep your regular retirement contributions on track.
Disability insurance can help protect your income (and retirement savings) if you are unable to work.
Step 3: Consider Long-Term Disability Insurance
Disability insurance can replace lost income if a person is unable to work. As with life insurance, many people may have some disability coverage as an employee benefit, but that isn't always adequate. Social Security Disability Insurance (SSDI) is another possibility,2 although its benefits are modest, and qualifying for it can be difficult.
People can also buy a disability policy from a private insurer. There are several types of disability insurance policies. An own-occupation policy covers someone who can no longer work in their previous field due to a disability, while an any-occupation policy covers someone who can no longer work at all.
If you're shopping for disability coverage, look for a guaranteed renewable and non-cancellable policy that ensures that premiums won’t increase and re-qualifying won't become an issue. The policy stays active as long as the premiums are paid.
Step 4: Invest the Rest
"Buy term and invest the rest" is a famous saying in the world of personal finance, the "rest" being the difference between the price of a term life policy and a permanent life one. As noted above, you may want to devote some of that surplus to building an emergency fund and buying disability coverage. But where should you invest the remaining money (and any other disposable income you can spare)?
If retirement is your end goal, a tax-advantaged retirement account, such as a traditional or Roth IRA could be your best bet, assuming you meet the income limits and other requirements. Maxing out on your 401(k) or similar plan at work is another option if you aren't already doing so. (If your goal is more immediate than retirement, bear in mind that you usually have to be at least 59½ to take money out of a retirement account without penalties.)
If you don't qualify for those kinds of accounts, you can always invest outside of a retirement account, although you won't enjoy all of the tax benefits. One low-cost option to consider would be an index fund from a mutual fund company or brokerage firm.
The Bottom Line
People may not think of term life insurance as a way to help meet their retirement-planning goals. Yet for many pre-retirees, term life (along with investing the money it saves you) can be an essential part of an effective strategy.