It can, to a point. But there are rules you must follow.
- You can choose a beneficiary for your IRA if you die before you tap that money.
- An IRA can leave your spouse with a nice amount of money, but they may not be able to access it tax-free.
- A Roth IRA will give you money tax-free, but you will pay taxes on the money before it is invested.
Many people draw money in a IRA accounts year after year so they can rest with a nice nest egg. If you started investing in your IRA in your early 20s and you’re now, say, in your 40s, you could have some nice cash in your name. And if you want to make sure your loved ones are financially protected in your absence, you might also consider buying life insurance if you don’t have a policy yet.
But do you need one? Let’s say you’re thinking of buying a $500,000 life insurance policy, but you have a $500,000 balance in your IRA. Is a joint IRA enough for your loved ones? Do you also need life insurance?
Survivors can get a lot of money with life insurance
Direct IRA rules can be very complicated. Life insurance premiums can also be regulated. But generally speaking, if you take out life insurance and you die, your beneficiaries will receive a tax-free payout. That may not be the case with an inherited IRA.
If you have money in a traditional IRA and your beneficiaries receive it when you die, they will usually pay taxes on that money. So, let’s say you want to leave your loved one $500,000 when you die. If you buy life insurance with that death benefit, your loved ones should walk away with $500,000 if you die while you still have the policy. With a $500,000 IRA, you might only end up with, say, $370,000 after taxes.
Now the rules are different and a Roth IRA. Roth IRAs don’t give you a tax break on contributions like traditional IRAs. One advantage of Roth IRAs is that you can enjoy tax-free withdrawals in retirement.
If you don’t make it to retirement, but, die before that milestone and leave your Roth IRA to your loved ones, they should be entitled to that money tax-free. But going back to a traditional IRA instead of life insurance can leave you with a smaller death benefit.
Make the right call
It’s easy to see why you might think that a large IRA balance can replace life insurance. But remember, the two have very different purposes.
The purpose of an IRA is to provide income for you during retirement. The point of life insurance is to protect your loved ones if you die while still providing them with financial support. It’s better to separate those two ideas — and buy life insurance even if you’re doing a great job of continuing to fund your IRA.
Also remember, if you die and leave your loved ones with a large IRA to inherit as well as a life insurance premium, you only have to giving them that extra protection. So if you can change the cost of life insurance, it’s worth getting.
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