IRA vs. Life Insurance: Costs, Pros & Cons

Updated

It’s been debated for years: which is better, an IRA or a life insurance policy? In some respects, that’s like asking, “Which is better, an economy car or a pickup truck?” Both will get you where you want to go, but one has more space for cargo and the other gets better gas mileage. They each have their pros and cons.

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Life insurance and IRAs are similar to that analogy. Life insurance has been around for well over 300 years and IRAs for almost 50 years. Both are valuable in a person’s financial plan, yet they serve two distinctly different purposes.

This article will compare IRAs and life insurance. We’ll look at who they’re designed for, when it makes sense to put money into one or the other, what their strengths and weaknesses are, and more.

Overview: Life Insurance vs. IRA

A good place to start is by looking briefly, with a high-level view, at what each of these financial products is. We can then zoom in and get a bit more granular about them.

Life insurance

Life insurance has been available to the public for centuries. The first company to offer life insurance was the Amicable Society for a Perpetual Assurance Office, founded in London in 1706. Since then, hundreds of life insurance companies are now in business, with annual industry sales in the tens of billions.

First and foremost, life insurance exists because it offers financial protection. It was designed to pay an agreed-upon death benefit (face amount) to a named beneficiary in consideration of payments (premiums) made by an individual to an insurance company. That’s pretty straightforward (term life insurance works like that).

Where it gets a bit more complicated is when you’re talking about the type of life insurance policy (permanent insurance) that will not only pay a death benefit, but a portion of every dollar paid in premiums also accumulates as savings (cash value) in the policy, and can ultimately be borrowed or withdrawn. (We’ll look at that in a bit more detail shortly.)

Permanent life insurance comes in a variety of types you’ve probably heard of: whole life insurance, universal life insurance, variable life insurance, survivorship life insurance, and others. Their common denominator: they all accumulate cash value in addition to paying a death benefit.

Life insurance wasn’t intended to accumulate cash value when it was introduced long ago. It was strictly intended to provide families with a lump sum of money when the income-earner passed away. It has certainly evolved since then.

IRA

The Individual Retirement Account (IRA) was established in 1974 by the Employee Retirement Income Security Act of 1974 (ERISA). The primary reason IRAs were created was to provide a tax-advantaged retirement plan to employees of businesses that were unable to provide a pension plan. They were also designed to be a vehicle for preserving the tax-deferred status of qualified plan assets at the termination of employment (through rollovers).

An IRA provides no life insurance payout in the event of the death of the owner. It was intended to be a product that solely helped people save money for retirement while getting a tax break for doing it, and it has remained that way. 

Life Insurance vs. IRA: Payouts or Payment Schedule

Payouts are very different for an IRA vs. a life insurance policy.

Life insurance payouts

A life insurance payout is made by the life insurance company to a named beneficiary when the insured dies. Beneficiaries can select a payout method from four different choices:

  • Lump-sum fixed amount: This is the most often selected type of payout. Beneficiaries who select this option receive the entire death benefit in one lump-sum payment. Though it’s the most popular, it can also be risky if the funds aren’t managed properly, which is why the other three payout types were created.
  • Specific income payout: Beneficiaries can choose to receive monthly installments over a set period of time to ensure the payout isn’t depleted too quickly. This payout is also known as “the spendthrift clause.”
  • Retained asset account: This operates much like a checking account. When a death benefit is paid to the beneficiary, the proceeds are placed in an interest-bearing account. The beneficiaries receive a checkbook if they would like to access the cash, and any interest earned becomes taxable on the amount the check was written for.
  • Annuity: Also known as a life income payout, this option guarantees payment installments for as long as a beneficiary lives. The installment amount is calculated using the beneficiary’s age when they file the death claim. If a lifetime payout option with an annuity is selected and the beneficiary dies before all of the death benefit is paid out, the insurance company will keep the remaining amount.

IRA payouts

An IRA payout is similar to a life insurance payout in some respects but much different in others. 

They’re similar in the respect that you name a beneficiary when you set up your account, and when you die, your beneficiary will receive any money that was not withdrawn.

They differ in that the beneficiary of an IRA, if they’re not a spouse, must withdraw all of the funds within 10 years of the original owner’s death. This is known as the 10-year rule. However, some beneficiaries are exempt from this rule:

  • A surviving spouse
  • A chronically ill or disabled person
  • A minor child
  • A person not more than 10 years younger than the IRA account owner

Life Insurance vs. IRA: Costs

The costs of life insurance and IRAs are much different, starting with nomenclature. A life insurance payment is called a premium, and money deposited into an IRA is a contribution.

Premium payment amounts for an individual life insurance policy are virtually unlimited (not necessarily the case for business life insurance strategies) because the face amounts of life insurance that can be purchased are unlimited.

For example, a spouse could decide to spend $30 per month on a term life insurance policy with a $100,000 face amount with their spouse as the beneficiary, or $3,000 per month on a $5 million life insurance policy.

An IRA’s cost is also flexible for the owner, but there are limits dictated by the tax laws. The contribution limit for IRAs in 2021 is $6,000 per year ($7,000 if you’re age 50 or older). They are set to remain the same in 2022.

Life Insurance vs. IRA: Who Are They For?

Since life insurance and IRAs were designed for two different purposes, they are beneficial to two types of people (with one exception).

A person who buys life insurance is primarily interested in helping other people when they apply for a policy. The life insurance death benefit helps beneficiaries in a number of ways, including:

  • Replacing a spouse's income
  • Paying for children’s college education
  • Paying off a mortgage so a family can stay in their home
  • To provide funds for someone responsible for funeral costs

Someone who contributes to an IRA does so primarily to enjoy a comfortable retirement and get tax breaks while funding it. Granted, a surviving spouse can benefit as the beneficiary of the IRA, but that is rarely the primary purpose.

The exception mentioned above pertains to someone who uses a permanent life insurance policy to not only pay a death benefit to a beneficiary but also to save money for retirement, with tax benefits.

As mentioned earlier, the cash value in a personal life insurance policy can be withdrawn or borrowed. Some people buy a permanent policy intending to take money out of their policy to help fund their retirement, making it a good choice for someone who not only needs to leave a large sum of money to their survivors but also wants to maintain their lifestyle when they get older.

Pros and Cons of Life Insurance and IRAs

Everything in life has pros and cons, including financial products like life insurance and IRAs. 

The big plus of a life insurance policy is that it immediately creates a large death benefit, even if only one premium payment has been made before the policyholder dies.

A significant negative of life insurance is the cost. As much as 50% of the first year’s premium can go towards paying a commission to the life insurance agent, not to mention the monthly administrative costs and policy fees the insurance company charges each month.

The biggest benefit of an IRA is its tax advantages. Contributions made to a traditional IRA are tax-deductible and until the money is withdrawn. It grows tax-deferred, meaning no taxes are paid on the investment growth. Taxes do have to be paid on the amount withdrawn.

The biggest downside of an IRA is the contribution limits (discussed previously). For that reason, many self-employed individuals use a different type of retirement plan that allows them to contribute more each year and enjoy the same tax benefits as an individual IRA (like a SEP-IRA or an individual 401(k) plan).

Should You Get Life Insurance, an IRA, or Both?

As you’ve seen, both life insurance and IRAs have their place in someone’s financial plan. Here are three things to ponder as you formulate your financial plan:

  1. You should buy life insurance if someone is dependent on you financially. 
  2. You should contribute to an IRA if you need to save money for retirement and either don’t have a retirement plan where you work or you’ve reached the maximum contribution limit for the year.
  3. You should consider investing in both when someone would suffer financially if you died and you also want to set money aside for your golden years.

Final Thoughts 

The best person to advise you on the merits of having life insurance, an IRA, or both, is an unbiased financial planner who receives no commission from selling life insurance and is paid a small fee on your IRA assets.

You don’t want to ask your uncle who’s a life insurance agent or nephew who’s a stockbroker which way you should go. Well-meaning friends and coworkers also have their own biases, particularly when it comes to life insurance.

Whatever you decide to do, take action as soon as you can. Life insurance is less expensive when you’re younger, and IRA balances grow larger over time.

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