Both Roth IRAs and cash value, or permanent, life insurance policies offer compelling tax benefits for the right people. The tax regimens on both products are very similar: Contributions or premium payments are not tax deductible in the current year. However, assets held within them grow free of federal income tax, and you can draw tax free income from either one of them. The difference is that the Roth IRA is primarily an investment vehicle, while cash value life insurance is an insurance product. While they share tax benefits, they are designed to do different things.
Advantages of a Roth IRA
Roth IRAs are not products. They are simply a type of account that provides tax advantages to the stocks, bonds, funds or other assets held within them. Roth IRAs give the account holder a tremendous amount of flexibility when it comes to choosing investments. Expenses in stock mutual funds and direct investment in exchange-traded funds, stocks and bonds are frequently lower than with cash value life insurance -- especially in the short term. This is due to the cost of insurance itself, as well as to the commission structure of life insurance products: A life insurance agent typically earns 50 percent of your first year premium or more on the sale. You don't write the check, but if you buy a permanent life insurance contract, you will usually have less cash value than you contributed to the policy in the early years of the contract, unless you are transferring a lump sum.
Types of Cash Value Life Insurance
There are two broad varieties of cash value, or permanent life insurance: whole life insurance and universal life insurance. Whole life policies guarantee a minimum death benefit, and a level premium for life, or for a designated period. You can pay more in premium to ensure the plan is paid up for life. Cash values grow gradually and are guaranteed never to go down. The policy has a guaranteed minimum crediting rating plus dividends, if applicable, which represent the policy-holder's share of company profits, and grow tax free, provided they are credited directly to the policy. Universal life policies, on the other hand, provide for a flexible premium and variable cash value. They can be fixed or variable products. Fixed products pay a steady interest rate on cash values, while variable life insurance policy cash values can rise or fall with market events.
Advantages of Life Insurance
Life insurance is unique among investment or savings vehicles in that they will provide a large tax-free death benefit to the beneficiary in the event the insured dies. This is the primary reason to buy life insurance. You can also buy a policy with a disability rider -- which means if you become disabled and can't work, the insurance company will pay whatever premiums you had already scheduled to pay. This allows you to complete a retirement or college savings funding plan even if you cannot work anymore. Life insurance cash values also don't impose a 10 percent penalty on withdrawals. You can access your cash value in a policy penalty-free, at any time, and for any reason.
Cash value life insurance works best if you have a long time -- at least 15 years -- before you need to start taking money out, and if you need the life insurance coverage anyway. As a savings vehicle, it works best if you overfund the policy -- putting as much cash in the policy as you can to grow tax free -- and keep your death benefit relatively low. You need to have some free cash flow to do this consistently. Roth IRAs may work best for those on tighter budgets, or who do not need the life insurance and already have significant disability income insurance.
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