The Max-Funded Policy as a Retirement Engine
Clare, 52, is a divorced hospital administrator earning $185,000. She contributes the maximum to her 401(k) including catch-up and has $520,000 there; she also has $90,000 in a taxable brokerage account and a $250,000 term policy with six years remaining. After expenses she has about $30,000 of surplus cash flow each year. An agent recommends a max-funded indexed universal life policy: $30,000 a year for 13 years, $600,000 death benefit, projected to produce $45,000 a year of tax-free retirement income from age 65 to 90 through policy loans at 5%, assuming 6.5% index crediting and the 0% floor. The illustration shows $1.9 million of cash value at 65 and first-year surrender charges of roughly 10% of premium. Clare's goals are to retire at 65 on $110,000 of income and to leave something to her two adult children.
1. Before debating rates of return, what tax and regulatory limits govern the $30,000 premium, and why do they matter to the income projection?
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Verify the 7-pay limit first. A life policy funded faster than the 7-pay premium becomes a modified endowment contract. A $600,000 death benefit with $30,000 of annual premium is close enough to the line that the answer must come from the carrier, not the agent's recollection. Ask in writing for the 7-pay premium and the guideline annual premium for that face amount, and compare each year's premium to the limit.
If it is a MEC:
- Distributions are taxed LIFO (gain first) instead of basis first, so the projected $45,000 a year arrives taxable rather than tax-free until basis is exhausted.
- The 10% penalty applies to distributions before age 59 1/2 (Clare will be 65, so not a factor here).
- If the policy later lapses with loans outstanding, the full gain, including loan proceeds, becomes taxable income in a single year.
- The death benefit remains income-tax-free under section 101(a), so a MEC is not fatal if the only objective is a legacy.
Why it matters: the entire selling point is tax-free retirement income. If the contract is a MEC, the sales rationale collapses even though the death benefit survives. Clare should also confirm the illustration discloses the MEC limit and that the agent has documented the basis of the projection.
Raise the face amount if necessary. The cleanest fix for a premium that exceeds the 7-pay limit is a larger death benefit, which raises the limit and costs little at her age.
2. Stress-test the $45,000 income stream. What happens at 4% crediting, and why is the loan rate the critical variable?
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The mechanics. Policy loans are not taxable, but they accrue interest and are secured by the policy. Money out the door at 5% must be earned back at more than 5% plus cost of insurance and expense charges, or the policy's net cash value declines each year while the loan balance grows.
At 6.5% crediting: the spread is positive and the projection may hold, though the 6.5% is not guaranteed and index caps and participation rates are declared annually.
At 4% crediting: the loan rate exceeds crediting by roughly a point, so the arbitrage reverses. Each $45,000 withdrawal accelerates the decline and the lapse date moves forward, potentially into Clare's late seventies, exactly when she has no other liquid source.
The failure mode is a lapse with loans outstanding. If the policy terminates, the difference between the loan balance plus cash value and her basis becomes taxable income in one year, on a policy she no longer owns. That is the "phantom income" scenario regulators cite.
What to demand: the guaranteed illustration run with the same withdrawal schedule, the year the guaranteed column lapses, whether loans are wash loans that continue to receive index credit, whether the loan rate is fixed or variable, and the surrender charge schedule by year. If the guaranteed column lapses before 90, the plan is a projection, not a plan.
3. Compare this proposal with Clare's alternatives and state what you would recommend.
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Start with need. Clare's dependents are adults. She has no income-replacement need beyond a modest final-expense and legacy amount, so the $600,000 death benefit is a byproduct, not a justification. Her real problem is a retirement income gap and tax diversification.
Alternatives, in order:
- 401(k) already maximized; confirm the employer match and the fund expenses, and consider whether a Roth 401(k) election suits her future tax rate.
- Backdoor Roth IRA ($7,000 plus catch-up at her age), giving tax-free growth and no RMDs at a fraction of the cost and with full liquidity.
- Taxable brokerage, which is liquid, has no surrender charge, and receives a step-up at death for her children.
- HSA if she is on a high-deductible plan, which is the most tax-favored account available.
What the policy provides that the others do not: tax-deferred growth with no contribution cap, tax-free access through loans, and a death benefit outside probate if properly owned.
Recommendation: reduce the premium to the 7-pay limit with a face amount large enough to carry it, cap the commitment at an amount she could sustain through a job change, verify the guaranteed column, and fund the bulk of retirement through the Roth and taxable accounts. Treat the policy as the conservative, bond-like sleeve of the portfolio with a legacy overlay, not as the engine of the retirement plan. Keep the existing term policy, since its conversion privilege is worth more than its death benefit at her current need level. Document all of this: an indexed UL sold to a 52-year-old on illustrated income is a supervisory priority.