When an adviser pitches universal life
Insurance is crucial for most families - but not as a retirement savings plan.
By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- My husband and I are in our 30s and have retirement plans through our employers. We've been working with an insurance agent who wants my husband to forego funding his 401(k) plan, which doesn't offer company matching funds, and instead invest for retirement through a universal life policy.

The idea is that once we reach age 60 we'll begin making withdrawals from the policy's cash value. Does this seem like a good way to plan for retirement? - Taunya P., Mountain Home, Idaho

It may be a good way for the agent to plan for his retirement. He gets a nice commission for selling you the universal life policy - which directs part of your premium toward insurance coverage and the rest into an investment or savings component that can grow in value over the years.

But although I'm all for insurance as a way to protect a family in the event a breadwinner dies - in which case, basic term insurance works just fine - I think it's a lousy way for you and your husband to save for retirement.

Where to begin?

First, if your husband follows the agent's advice of doing the life insurance policy instead of the 401(k), you and your hubby are giving up a very nice tax break - namely, the money you contribute to the 401(k) isn't taxed until you withdraw it. The life insurance policy offers no such upfront break. So on that basis alone, I'd say the 401(k) is the better deal.

You mention that your husband's 401(k) plan doesn't include an employer match. Granted, the plan would be much more lucrative if it did. But is the life insurance company kicking in money to the insurance plan? I doubt it. And even if the company did offer some sort of bonus for funding the insurance plan (as insurers sometimes do in the case of annuities), that inducement would likely come with all sorts of conditions that would undermine its value.

So at the very least, I think it makes no sense for your husband to use life insurance as a retirement savings vehicle before funding his 401(k) plan to the max. And in fact I think most responsible insurance agents and other advisers would agree with me on this point.

What if you're already maxing out

Now, I expect some insurance agent and advisers - many, in fact - would say that once you've maxed out on options like a 401(k) and IRA, then life insurance becomes a splendid way to save for retirement.

But I don't agree. Even if your husband goes all the way with his 401(k) and then does an IRA, I still don't think it's usually a good idea to save for retirement using universal life insurance (or variable universal life insurance, which is usually the policy of choice for such pitches, or any type of life insurance, for that matter).

The appeal to investing via life insurance is that investment gains go untaxed as long as they remain in the policy. Of course, once you withdraw those gains, you pay tax on them at ordinary income rates that can go as high as 35 percent.

Agents, however, will often point out that there's a way around this tax bite. By borrowing against the policy instead of making outright withdrawals, you can pull out your gains without paying tax. That's because loan proceeds aren't taxable. The suggestion is that you'll earn tax-free returns.

But there are several rubs here. For one thing, insurance policies usually siphon off quite a bit of your return through a variety of fees. Those charges can drag down your return considerably.

There's another risk. Once you start borrowing from a policy, you must keep it in force. If the policy lapses, the investment earnings you borrowed become taxable. If that happens after many years of withdrawals late in retirement, you could end up with a big tax bill just when you're not in a very good position to pay it.

Why would I want a retirement plan that involves that kind of risk, not to mention big fees? If you've funded your 401(k) to the max, contributed as much as possible to an IRA and you still have money left to save, then why not check out investments like index funds and tax-managed funds?

You'll owe taxes on your investment gains in these options. But you should be able to postpone paying taxes on any significant gains in these investments for a long time. And when you do pay, you should for the most part be taxed at the rate on long-term capital gains, which maxes out at 15 percent. (For more on how the tax benefits of index funds and tax-managed funds, click here.)

So my advice is that your husband should stick with that 401(k). Beyond that, I think you and your hubby also ought to consider consulting another adviser, preferably one who doesn't default to insurance as the all-purpose retirement-planning solution. (For help in that task, check out this earlier column I wrote on choosing an adviser.)

Life insurance is an important part of a well-rounded financial plan. But it's not the answer to every problem, and when it's misused, it can become a huge problem itself.

_______________________________

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.