A LIRP is a retirement plan that uses the cash value of permanent life insurance policies, such as whole life and universal life insurance, to retain retirement assets. The tactic demands you accumulate a cash value that you may later use as a source of supplementary income throughout your retirement years. At some point in the future, you may be able to withdraw money from the cash value of your policy or take out loans against it to pay for items during your retirement.

Using life insurance as a source of income may make sense for a person who already has a life insurance policy that has accumulated a large cash value and does not need insurance protection at this time (or who anticipates that they will not want it when they retire). Those who want to reduce their exposure to market risk may also be interested in the approach, but other options may be a better match for them.

How Does a LIRP Work?

Permanent life insurance plans often come with a cash value component that has the potential to increase over time. When you pay premiums into a policy, the amount you pay is often more than what is necessary to offer protection from life insurance and keep your policy in force. The surplus funds increase the value of the cash. Any increase in your cash worth is subject to tax deferral, and if you wait several years, you might end up with a sizeable sum of money.

If you have a LIRP, the source of your supplementary income will be the policy's cash value. You have two options for accessing your policy's cash value: either take out a loan against it or withdraw the money. Although none of these kinds of income may be subject to taxes, there are several restrictions and possible repercussions that come with accessing your cash value:

• Once you have taken out more money from your insurance than you have contributed, all withdrawals you make beyond that point may be subject to taxation.
• When you take out a loan, you will accrue interest charges, and if you pass away with a loan sum that is not paid off, your heirs will get a lower death benefit.

Withdrawals

If you withdraw from your account, you must be aware of the costs of surrender. If you're still in the surrender period, the insurance company may apply penalty costs that lower the profits if you're still in that time; normally, these are the early years of your policy, but they may extend up to 20 years. These fees vary depending on how long you've had your policy.

You must be informed of the applicable tax laws to successfully build up the cash value of your permanent life insurance policy. If you donate more money to the insurance than the restrictions set out by the IRS, for instance, the policy may transition into a modified endowment contract (MEC). Because of the increased likelihood that your withdrawals would be subject to taxation, a plan that depends on life insurance as a possible source for tax-free retirement money would be rendered ineffective if this scenario occurred.

Loans

In the case of a loan, as opposed to withdrawal, interest is paid on amount considered to be "loaned," yet same amount can earn interest as component of cash value. Your debt-to-income ratio will not change due to taking out a loan to pay for life insurance. In addition, you won't have to worry about being approved for a life insurance loan. No matter your credit score, you will be able to collect the money from your cash value if it is accessible.

LIRP Example

Despite the potential risks, life insurance plans make it quite simple to retrieve the money in the policy. Compared to retirement accounts such as IRAs and 401(k) plans, loans and withdrawals may allow easier access to monies exempt from taxation before the age of 59 ½.

Consider the following hypothetical scenario: you and your loved ones no longer need the permanent life insurance coverage provided by your own old policy. You can receive supplementary income from the insurance if your current tax status makes it unfeasible to cash out the policy and reinvest the funds, which are valid reasons.

Many different types of plans are available, including whole life, universal life, and variable life insurance policies. When it comes to cash value growth, whole life insurance plans are known to provide the highest degree of predictability; nevertheless, the profits from universal and variable policies have the potential to outperform the growth that is included inside whole life policies.

If you decide to take money out of an insurance policy, you can take out loans or just take the money outright. For instance, if the assets in your IRA suffer losses due to a market crisis, it may be prudent to withdraw money from your life insurance policy rather than your IRA.