How to get the most from this tax-free source of retirement income

Roth IRAs and Roth 401(k) plans aren’t your only sources of tax-free income in retirement.

Say hello to so-called permanent life insurance — a policy with an interest-bearing account that’s known as cash value.

This cash value accumulates without being subject to capital gains taxes, and the interest rate it accumulates can beat what you’ll get in a traditional savings account.

“It’s been one of my best fixed income investments because the cash value grows at more than 4% a year consistently,” said Glenn Daily, a fee-only insurance consultant in New York. It’s “a low-risk and tax-deferred fixed income investment with easy access to policy loans.”

The 66-year-old has a whole life insurance contract that his parents bought for him when he was 12 years old. Daily pays fixed premiums of $253 a year to maintain it.

A policy loan on life insurance can offer investors a source of liquidity and tax-free income in retirement.

But there’s a catch: If you botch this move, you can be on the hook for taxes and you might destroy the policy altogether.

Term insurance might cover you for a limited period, perhaps 10 or 20 years.

However, permanent life insurance tends to be the tool of choice to protect your heirs from estate taxes.

That’s because the coverage remains in place if you keep paying the premiums, and the death benefit is tax-free.

Permanent life insurance also includes a cash value savings account, which can grow in different ways.

Whole life offers a cash value account that grows at a guaranteed rate of interest that’s set by the insurance company.

Some insurers pay a dividend, which clients can use to purchase additional coverage. Customers pay a fixed premium for the duration of the policy.

Universal life also has a cash value account that grows based on a minimum interest crediting rate that’s established by the company. If the insurer’s own underlying investments fare well, the company may pay additional interest toward your cash value.

Customers pay flexible premiums with universal life insurance, which means that you may be able to skip premium payments if your cash value is sufficient to cover the policy’s costs.

Companies also offer different varieties of universal life, sometimes pegging the cash value growth to an index, for instance.

Variable life links the growth of your cash value to underlying investments known as subaccounts, which are like mutual funds.

Expect to pay more than you would for simple term insurance to obtain permanent coverage.

A healthy 50-year-old man may pay $21,726 per year for a whole life insurance policy with $1 million in death benefits, according to NerdWallet.

In contrast, he would pay $2,927 annually for a 30-year term policy with the same death benefit, the personal finance website found.

If you were to withdraw cash from your policy up to the amount you had originally invested, you would receive it free of taxes, but any earnings that are taken out may be subject to income taxes.

That’s why loans are attractive: If you borrow, you use the policy as collateral and take a tax-free loan from the cash value.

“I don’t see it as a primary investment that you should put all of your funds into,” said Jason Wellmann, head of distribution for life insurance at Allianz Life. The insurer offers indexed universal life insurance policies.

“Rather it’s a complement, whether it’s retirement or emergency funding,” he said.

Also, the interest rate for repayment is generally low — 4.29% in Daily’s case — when compared with the top rate of 36% you might find on a personal loan or the average 17.7% interest rate you’ll find on a credit card.

One reason to borrow from your policy might be to manage your modified adjusted gross income and tamp down Medicare costs.

That’s because retirees with an MAGI that exceeds $85,000 if single ($170,000 if married and filing jointly) are on the hook for higher Medicare Part B premiums.

See below.

Money from the loan won’t bump you into a higher income bracket.

“It’s a great tool for unexpected expenses,” said Tom Love, vice president of insurance analytics at ValMark Financial Group. “If you used a 401(k) for those costs, you would incur income taxes and you can have tax bracket creep.”

But be aware that borrowing — especially if you take regular loans without repaying them — can also go wrong.

Policy loans become problematic when individuals borrow so much they can’t afford to pay the premiums and loan interest.

At the same time, if an over-stretched borrower ceased paying premiums and allowed the policy to lapse, he would get a tax bill, too.

For instance: Your policy has $100,000 in cash value. You have paid $50,000 in premiums, which is your cost basis.

If you allow the policy to lapse, you end up owing income taxes on your gain of $50,000 — the difference between the cash value and your original investment.

“You can accumulate loans so great that they cannibalize the policy and you’re in a ‘damned if you do, damned if you don’t situation,” said Scott Witt, founder of Witt Actuarial Services.

Another thing to bear in mind is that the Federal Reserve’s recent decision to cut a key interest rate — as well as the long-term trend of lower interest rates — affects insurance companies.

Insurers invest in bonds, and lengthy periods of low interest rates affect the return they earn.

“As bond portfolios mature, they can’t invest safely at a higher rate,” said Tom Henske, certified financial planner and partner at Lenox Advisors in New York. “When that happens, they lower their crediting rate.”

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“If we get into a three-year window of low interest rates, such that the rate you pay on the policy loan is higher than the crediting rate, then that’s not good,” he said.

Similarly, holders of variable life insurance policies who take large loans from their policies must be mindful of how a long market decline might affect them.

“If you were counting on having a big cushion between the account value and the loan amount, that cushion erodes when the account value goes down,” said Daily.

“There’s a greater risk that the loan will impair policy performance,” he said.

If you already own cash value life insurance, be sure to revisit it with your financial advisor to check on your cash value and make sure its performance is on track.

Review the contract annually if you have a pending loan, said Love at ValMark.

Avoid purchasing cash value life insurance for the express purpose of drawing it down in retirement, advisors said.

“When I buy my permanent life insurance policy, if I ever need it I could use it in retirement, but you should never buy it for that purpose,” said Brett Danko, a CFP and founder of Main Street Financial Solutions in Newtown, Pennsylvania.

“The key is to only buy life insurance when you need it,” he said.