Can life insurance help you retire faster?

Choosing the Right Policy

Not all types of life insurance are ideal for helping you retire early. Term life is the cheapest, but it doesn’t come with the savings and investment perks (a.k.a. cash value) that permanent life insurance does.

Term life can improve your financial health, but it won't directly help you save for retirement. To do that, you need a permanent life insurance policy, which comes in two basic forms: whole life and universal life.

Whole life insurance

Whole life is often the most expensive type of policy you can buy, but it's as close to a sure thing as cash value gets. Whole life comes with guaranteed cash value growth at a guaranteed rate. It also has a level premium and death benefit, so you know exactly what you're getting.

Universal life insurance

Universal life policies are often cheaper than whole life and come with more flexibility. You can adjust your premiums and death benefit over the life of the policy, for example. But this flexibility comes with fewer guarantees. If you don’t fund your policy properly, your cash value growth may stagnate, and you could lose your coverage.

There are several types of universal life insurance, and some are better suited to helping you fund your retirement than others.

Indexed universal ties your cash value growth to an index, such as the S&P 500. While your cash value won’t be directly invested in the stock market, its growth will rise and fall with the stock market—typically a few points below the actual index it follows. While your coverage isn't guaranteed, most insurers ensure your interest rate never drops below zero.

Variable universal allows you to invest your cash value directly in the stock market, with all the risks and returns that come with it. If you're interested in a variable policy, you'll need to work with a life insurance agent who has a securities license.

There are also straight universal life policies, which earn interest independently from the stock market. How quickly you gain interest depends on your policy.

To retire early, steer clear of a guaranteed universal policy. While you won't risk your coverage if interest rates drop, the trade-off is glacially slow growth, which will likely leave you with too small a cash value to boost your retirement income.

Mutual Companies and Participating Policies

In addition to choosing the type of policy, you can boost your cash value growth and add other benefits by purchasing coverage from a mutual company. Instead of being owned by stockholders, mutual companies are owned by policyholders.

Mutual insurance companies usually offer at least one participating policy—one that can earn dividends. You can use these dividends to boost your retirement savings by allowing them to collect interest alongside your cash value. Or, if you experience a lean year, you could pay your life insurance premiums with those dividends to keep your policy in place, since cash value life insurance can be rather expensive.

How to Fund Your Policy

Typically, life insurance policies grow cash value until it meets or approaches the death benefit you choose, at which time the policy matures. So if you buy a $1 million policy, your cash value should reach $1 million by a specific age, usually 80, 90, or 100. You probably can't wait that long if you're planning to retire early.

Let’s look at some numbers to find out how much to fund your policy.

Crunching the Numbers

This is the part where we really roll up our sleeves and dive deep into the figures of this strategy so please bear with me. I assure you that I don’t intend for this to read like a word problem on the SAT.

Let’s say you want your life insurance policy to boost your retirement income by $25,000. That means taking a policy loan of $25,000 each year for the foreseeable future. And let’s say that your cash value grows at a steady interest rate of 2% per year. How much cash value would you need to start with to ensure it never runs out?

For an annual income boost of $25,000, you’d need a starting cash value of $1,275,000.

Here’s how that breaks down:

$1,275,000 Starting cash value

• $25,000 Policy loan

= $1,250,000 Remaining cash value

x 1.02 For a 2% annual interest rate

= $1,275,000 End-of-year cash value

You’d start the year with $1,275,000 in cash value. In January, you’ll take out a $25,000 policy loan, leaving $1,250,000 in cash value. Over the year, you’ll earn 2% interest on that $1,250,000, which comes to $25,000, enough to entirely replace the initial loan. By the following January, you’ll be ready to take out another $25,000 loan—all without permanently draining your cash value.

If you want a higher income boost using this strategy, you’ll need a higher cash value. If you don’t need as much annual income, you can get away with a lower starting cash value. To figure out how much cash value you’ll need, use the following formula:

Let’s say you want to double your income to $50,000 annually. Would you have to double your starting cash value? Let’s find out.

$50,000 x 1.02 / .02 = $2,550,000

Yes, $2,550,000 is exactly double $1,2750,000 the starting cash value we used in the first example.

Now that you know what cash value to shoot for, it’s time to choose the size (death benefit) of your life insurance policy.

Policy Size and Funding

Remember that your cash value is designed to reach your death benefit on a specific maturity date. But because maturity dates are usually long after you plan to retire, you shouldn’t choose a death benefit that’s the same as your cash value.

If you buy a $1,275,000 policy based on the example above, your cash value wouldn’t hit that amount until long after you stop working, even if you were shooting for a normal retirement timeline. Instead, you have two options for bulking up your cash value faster.

Buy a Bigger Policy

Instead of $1,275,000, you could choose a policy with $5 million or more in coverage. Your premiums would be much higher, and you’d reach $1,275,000 in cash value much sooner. If you need only $1,275,000 if coverage, however, you could be wasting money. Remember that a portion of your premium goes toward funding your death benefit. The higher the death benefit, the more you’ll pay for it.

Fund your policy early

Instead of buying a larger policy than you need, you could fund your policy early so that your cash value reaches your desired amount when you plan to retire. How you fund your policy early depends on the type of coverage you buy. With a universal life policy, you can simply pay more than the minimum premium, since that flexibility is already built in.

Whole life policies, however, have fixed payment plans. If you want this type of policy, you'll have to choose one that allows for early funding. If you're going to retire in 20 years, for example, you might select a 20-pay whole life policy. As its name suggests, this policy is designed to be paid up in 20 annual premium payments.

Your premiums will be more expensive than a standard whole life policy because you’ll be racing to pay for your entire death benefit and grow your cash value quickly. But you'll save money overall because you won’t be paying for an exorbitant death benefit. Meanwhile, you’ll collect more money in your cash value account early on—allowing you to take advantage of compound interest.

Should Life Insurance Be Part of My Retirement Plan?

If you're considering using life insurance to help you fund early retirement, you should know that there are some downsides to this strategy.

It’s easy to get caught up in the savings aspect of cash value life insurance, but don’t forget that part of your premiums go toward permanent life insurance coverage.

As mentioned above, to ensure you can take out a substantial policy loan each year without paying it back, you'll probably need to fund your policy heavily early on. And many people can't afford such a large investment in their early working years.

It’s easy to get caught up in the savings aspect of cash value life insurance, but don’t forget that part of your premiums go toward permanent life insurance coverage. If you don’t need that coverage, it might be better to buy an inexpensive term policy (if you need life insurance at all) and invest the difference elsewhere.

Still, using life insurance policy loans to fund your retirement offers tax benefits that other investments may not. Uncle Sam doesn’t tax your policy loans or cash value growth, for example, unless you cancel your policy. And, except for the first seven years, there isn’t a cap on how much you can contribute annually (like an IRA). If you already need permanent life insurance and can pay it up quickly, a policy could make a great addition to your retirement fund. But if you don't need the coverage and don't have spare cash after investing in other retirement vehicles like a company-matched 401(k), then life insurance might not help you meet your early retirement goal. If you’re not sure, talk with a licensed insurance agent and your financial advisor.