Investment Grade Insurance Contracts v. Roth IRAs

The advantages and disadvantages of traditional qualified accounts, like IRAs and 401ks, are discussed in detail on our Investment Grade Insurance Contracts page. Here’s a recap:

  • In 2019, you can contribute up to $6,000 annually to an IRA and $18,000 to a 401k.

  • Every dollar you contribute in a tax year is a dollar less you have to pay taxes on (and if you’re the average American, that means a savings of 12.5 cents in taxes next year for every dollar contributed).

  • Your account grows with every new contribution and is also usually tied to the stock market (there are exceptions, e.g., a self-directed IRA), so while it will see gains over time, there is no guarantee what those gains will be (or if there will be any) or when a recession will take a big chunk out of your retirement.

  • You can’t touch the money until you are 59½ without paying a stiff early withdrawal penalties, and you have to start withdrawing the money when you are 70½, whether you want to or not (called required minimum distributions).

  • When you do start making withdrawals, presumably in retirement, every dollar you withdraw counts as income and is subject to the income tax rate in effect when you withdraw it, and there is no guarantee what that will be. (The government doesn’t promise you when you open your account that taxes won’t go up.)

A Roth IRA is almost the opposite of a traditional IRA. For one, Roth IRA contributions are made with after-tax dollars, which means (1) you pay taxes on the contributions in the year you make them, and (2) there is no tax deduction for contributions. Your contributions have the same limits as a traditional IRA ($6,000 annually), though in some circumstances you can double that if you are married, making contributions for each spouse.

You have total control over the accumulated contributions you have made to the Roth IRA and can withdraw them at any time without penalty or tax consequence. But the earnings on your contributions are subject to taxes and penalties for early withdrawal until you are 59½ years old. Additionally, under a Roth IRA, you are not required to make the required minimum distributions when you are 70½. The biggest advantage of a Roth IRA comes when you start making those withdrawals—they’re completely tax free. You’ve already paid taxes on them, and you don’t have to pay taxes on them again. That comes with a few major benefits:

  1. If you’re like most Americans, and you believe taxes will be higher in the future, not lower, than it is to your advantage to pay them now rather than later.

  2. If you pay taxes now you’re just paying on the principle. You don’t pay taxes on the withdrawal, even though some of what you withdraw will have been investment gains. With a traditional IRA, you take a deduction on the principal you contribute, but when you withdraw, you pay taxes on both the principal and the earnings.

  3. It may be easier for you to afford taxes while you are in the earning stage of your life (and you probably have a lot more tax deductions, like dependents who live at home, student loan and mortgage interest payments, business expenses, etc.). In the retirement phase of your life, you probably have fewer deductions and also potentially less earning potential, so keeping every dollar you withdraw will be much more important.

An investment grade insurance contract (IGIC) has many of the advantages of a Roth IRA, with a few added benefits.

Like with Roth IRAs, the money contributed to an investment grade insurance contract is made with after-tax dollars. And like with Roth IRAs, you can use the cash-value of your account without having to pay taxes (when you use the cash value as collateral for a loan, you pay zero taxes). Consider the following chart for a comparison of the attributes of an IRA, Roth IRA, and an investment grade insurance contract:

Attribute IGIC Roth IRA IRA
Tax deduction with contribution No No Yes
Maximum annual contribution No* $6,000 $6,000
Minimum age for penalty-free withdrawal None None† 59½
Required Minimum Distributions None None Start at 70½
Guaranteed returns Yes** No No
Income tax due on withdrawal No†† No Yes
Death benefit Yes No No
Long-term care benefit Yes No No
Health a factor for eligibility Yes No No
Income a factor for eligibility No Yes*** No
Passes tax free to heirs Yes Yes No

*When you negotiate your insurance contract, you pick the amount of premiums you pay annually, which is limited only by your income and your insurable interest. If in the future you want to increase your maximum annual contribution, you can establish a new insurance contract.
†You can withdraw up to the amount of your contributions any time without penalty or tax. But to withdraw the earnings on your contributions without penalty or tax, you have to be at least 59½.
**There are a variety of insurance contracts. You can choose higher risk contracts, with potentially higher reward, or you can choose a contract that has a guaranteed minimum return, which is usally around 4% annually.
††You can withdraw up to the amount of your contributions without having to pay any penalties or taxes, but withdrawing the earnings on your contributions invokes tax consequences. But if set up right, you never withdraw from the IGIC, and instead take out loans against the cash value. Then there are no tax consequences.
***You are ineligible to make contributions to a Roth IRA if your modified adjusted gross income exceeds a certain amount. That amount for 2019 is $137,000 if you're single and $203,000 if you are married.

You see from the comparison that the one real drawback to an investment grade insurance contract is that health is a factor—you can only insure a life that is in decent health. But the insured does not have to be the owner of the contract. You could create an IGIC on a spouse, a child, or a key employee. That way almost anyone who wants an IGIC can use one.

Roth IRAs are a great investment vehicle and don’t come with the major drawbacks of a traditional IRA or 401k. But top income earners cannot use Roth IRAs, and no more than $6,000 can be contributed annually. And a great way to diversify your portfolio would be to have a higher risk Roth IRA (if you’re young and can afford to) and a low risk IGIC. Yes, you can do both!

If you have questions, or are interested in finding out more about investment grade insurance contracts, call the experts at the Fortune Law Firm.