Fact or Fiction: IULs can be a tax-free source of retirement income.
It seems that Indexed Universal Life (IUL) Insurance policies are being increasingly marketed as an alternative to the traditional IRA for purposes of generating income during retirement. I’ve seen it in some advertisements that come across my desk and have also noticed a trend in Internet articles touting IULs as a “good retirement investment” and a “tax-free retirement income source.” My guess is if you’re reading this, you are also a compliance professional, and your “Spidey sense” is tingling. You’re cringing at those all too common (and inaccurate) descriptors for insurance products. You know what I’m talking about—those words that raise our eyebrows: investment vehicle and tax-free.
It is engrained in the minds of us compliance folks to immediately get out the red pen with no questions asked when we see an insurance product or an annuity being described as an investment, but the concerns regarding the use of the term tax-free when referring to the income source that an IUL can provide for a consumer may not be so glaringly obvious. As a rule of thumb in the compliance world, if something sounds too good to be true, it probably is, but it is also probable that there is a more accurate way of describing the product feature that will help the consumer better understand what they’re buying. The product features of the IUL are no exception. Answer the questions sprinkled throughout from your compliance professional perspective and from that of a consumer. What would you want to know before deciding on funding your own retirement?
First ask yourself, is an IUL a tax-free source of retirement income? Not exactly. While it may be true that taking a loan against the death benefit of the policy is tax-free, there are other factors to consider before deciding that an IUL is an appropriate retirement income solution. This appealing tax-free status does not apply to all IUL distributions. In fact, a loan is the only tax-free way to access the cash value during retirement. Death benefits are also typically tax-free, but not useful to the retiree who is also the insured!
Depending on the performance of the indices, policy charges and expenses, among other things, the IUL could require additional premium payments to keep the policy in force. The alternative to paying the premiums owed is – you guessed it – no more policy. And in the worst case, no more retirement income plan. Is the retiree anticipating this potential expense during retirement? Are there other sources to draw from during retirement if needed? What if funds are needed during a surrender period?
Withdrawal of cash value is another option to access funds that is available to the retiree. In the withdrawal scenario, any distributions above the cost basis will be taxable. Depending on the funds used to establish the IUL, additional tax implications should be considered. For example, if an IRA was used to fund the IUL, it is likely that IRS penalties for an early distribution would apply for those who retire early. And don’t forget the taxes paid to convert the IRA to an IUL.
There are a lot of moving parts beyond those mentioned when it comes to using an IUL as a tax-efficient retirement income source, there’s no denying that. Just last week, the Oregon Division of Financial Regulation acknowledged the product type’s complexity by issuing a message to remind producers that they themselves should have a full understanding, not only of the policy, but of the type of insurance as well, to ensure that it is suitable for their customers’ needs.
So, what type of customers could potentially benefit from purchasing an IUL and utilizing it in this way? Generally speaking, high earners who are frustrated with the lack of flexibility of their tax-deferred accounts (think IRAs), who have maxed out their retirement accounts, who earn too much to qualify for a Roth IRA, or who feel limited by the amount of tax-deferred income that they can contribute to their 401(k).
This means that this strategy is not one that should be presented to any and every pre-retiree or retiree who walks in the door for business. There is no doubt that using an IUL to fund retirement income while also providing a death benefit is a good idea, but as we all know, what is good for one is not necessarily good for all. Any advertising or training material that promotes using an IUL in this way should make this clear. The message issued by Oregon reiterates this point but reminding producers of administrative rule OAR 836-080-009, which “prohibits a person from recommending to a consumer the purchase, sale or replacement of a life insurance policy without reasonable grounds to believe that the transaction is suitable for the consumer.”
Why is it notable to point out that this clarifies that the suitability standard in Oregon does apply to IUL policies, when this may not be the law in a lot of states? While Oregon’s application of this standard may go against the grain, it’s important to keep this idea of suitability in mind as a driving force to better understand the products that are being sold to consumers, especially when more complex products, like IULs, are being marketed and sold with such a specific strategy and use in mind. As compliance professionals, we have a responsibility to ensure that all products are appropriately described to protect and ultimately benefit the consumer. Just think, soon our “Spidey sense” can be used for something else!
The next time you see an ad for an IUL as a retirement strategy, ask yourself: Does it disclose or describe how it works? How does the tax-free terminology apply? Could the nest egg be lost completely? Is anything missing that could help you make an informed decision as a consumer?
