IRA vs. life insurance: Which is best for retirement saving?

You have several options when it comes to saving for retirement. An employer-sponsored plan such as a 401(k) or 403(b) is usually the best place to start, especially if they offer an employer match. But after that, you may consider contributing to an individual retirement account (IRA) or even use a life insurance policy as a way to save for your golden years.

Here’s what to know about the differences between an IRA and life insurance and what to watch out for if you decide to purchase a life insurance policy.

What is an IRA?

An IRA is a retirement savings vehicle that allows you to set aside money in an account that can be invested and grow tax-deferred until you reach retirement age. Individuals can contribute up to $6,500 to an IRA in 2023, or $7,500 if you’re age 50 or older. Your contributions can be invested in a variety of assets such as stocks, bonds and mutual funds, and you won’t pay taxes on the gains until you start withdrawing money during retirement.

There are two main types of IRAs to choose from:

• Traditional IRA: With a traditional IRA, contributions are made with pre-tax dollars and you could get a tax deduction in the year you make the contribution. Once you start making withdrawals during retirement, you’ll pay taxes on the full amount. You must start taking withdrawals once you reach age 73.
• Roth IRA: Contributions are made with after-tax dollars in a Roth IRA, which means you won’t get an upfront tax break, but withdrawals during retirement are completely tax free. Plus, you’re never required to make withdrawals from a Roth IRA.

Life insurance as a retirement savings tool

Most people probably think of life insurance as being a tool to protect your loved ones in the event of an unexpected death. Life insurance helps people manage that risk effectively, but it can also be used in other ways.

Permanent life insurance pays a death benefit to the policy’s beneficiaries, but also comes with a cash value component, which can build over time on a tax-deferred basis. This cash value can be borrowed against or withdrawn tax free as long as the amount doesn’t exceed what you’ve paid in premiums and the policy remains in place.

However, life insurance policies can be complex and expensive. High upfront fees go toward the agent’s commission and investment fees can also be high. It can take at least a decade for the cash value to build up in an account, according to Anh Le, a CPA and licensed life insurance agent in San Diego. Cashing out early will likely result in surrender charges that vary by provider, but that could run about 10 percent early on in the life of policy.

Le says the right policy will depend on a person’s individual circumstances, but certain features can be extremely beneficial such as living benefits and guaranteed lifetime income. Policy features will vary by provider and a good agent is needed to explain the costs and policy details.

Life insurance as an investment: When does it make sense?

For the vast majority of investors, it will make the most sense to start with tools designed specifically for retirement saving such as a 401(k) or IRA. But wealthy investors may find that they maximize those saving methods and aren’t able to contribute to Roth IRAs because of income restrictions. That’s where Le says life insurance can play a role.

Life insurance gives wealthy investors a way to build tax-free income that they aren’t able to create through the use of a Roth IRA. Life insurance policies don’t have the income restrictions or contribution limits of IRAs.

Le says young people may also benefit from life insurance policies because their premiums may be lower thanks to good health and they have a long time horizon. Life insurance generally gets more expensive as you age.

Bottom line

If you’re just getting started saving for retirement, your best option is likely to use traditional methods like 401(k) plans or IRAs to build up your portfolios. These accounts are designed specifically for retirement and are available at low costs with plenty of good investment options. Wealthy investors may benefit from using life insurance policies to create tax-free income, but be sure to understand the policy’s details and the fees you’ll be charged before signing on the dotted line.