The Risks of Marketing Life Insurance as Tax-Free Retirement

A client in his fifties asks a question you have heard in some form many times: if I put money into this policy now, can I take it out tax-free in retirement? The pitch he saw online said exactly that. The honest answer is that it depends on how the policy is built, how money is taken out, and whether the policy is still in force when he does it. "Tax-free retirement" leaves all three out.

This article looks at what sits behind that phrase when it is used for permanent and indexed life insurance. It covers the tax rules behind loans and withdrawals, what a lapse can do, how illustrations get misread, and what two NAIC models and one state's advertising rule say about describing these policies. It describes rules and is not tax or legal advice. Rules differ by state, product and carrier, so check your state insurance department, your carrier's compliance guide and a tax professional.

Is life insurance retirement income really tax-free?

Sometimes the tax treatment is favorable, but it is conditional. A contract that qualifies as life insurance under the federal definition becomes a modified endowment contract, or MEC, if it fails the 7-pay test. That test asks whether the premiums paid in the first seven contract years exceed the net level premiums that would have paid the contract up after seven level annual premiums.¹² The rule applies to contracts entered into on or after June 21, 1988.¹

For a MEC, the Internal Revenue Service, in a 2001 revenue procedure, describes taxation of non-annuity distributions as income first, treats loans and pledges of the contract's value as distributions in general, and adds a 10 percent additional tax on the taxable portion unless an exception applies, such as age 59 and a half or older.²³ A policy funded heavily and early can cross that line.¹ The statute treats a contract with a material change, which includes a death benefit increase with exceptions, as a new contract for the test.¹²

For life insurance contracts that are not MECs, section 72(e)(5) keeps an older rule, subject to Treasury regulations: an amount not received as an annuity is included in income only to the extent it exceeds the investment in the contract, and the rule also applies to amounts received on complete surrender.³ The IRS tells taxpayers that surrendering a policy for cash means including in income any proceeds above their cost.⁴ This describes what the statute and the IRS say. How a particular loan or withdrawal is taxed is a question for a tax professional, and it turns on the contract's tax status, not the product name.

What happens to the tax picture if the policy lapses?

California's Department of Insurance, in a guide revised in 2018, tells consumers that some cash value products may enjoy tax advantages while they remain active, and that a policy lapse or surrender may create a taxable event and may generate a Form 1099.⁵ It adds that outstanding loans are deducted from policy proceeds at death or at surrender, and it points readers to a tax advisor.⁵

A client who borrows against a policy for years is relying on the policy staying in force. If it ends, the result depends on the contract and the client's tax position, and it can be a tax bill with no policy left to show for it. "Tax-free" describes the best case. A fair description also names the case where the policy does not survive.

Why is an illustration not a promise of tax-free income?

The NAIC illustrations model regulation, Model 582, says its goals include ensuring that illustrations do not mislead purchasers of life insurance.⁶ It requires any illustration of non-guaranteed elements to carry a statement that benefits and values are not guaranteed, that the assumptions are subject to change by the insurer, and that actual results may be more or less favorable.⁶ The narrative summary must include a statement, in substance, that the illustrated elements are assumed to continue unchanged and that "This is not likely to occur."⁶

The model also has the agent sign. The producer's statement reads, in substance, that the agent explained that non-guaranteed elements are subject to change and has "made no statements that are inconsistent with the illustration."⁶ Presenting the illustrated column as the expected outcome runs against that required language. If an illustration lets policy charges be paid from non-guaranteed values, the model requires disclosure that a charge continues and that the premium payer may need to continue or resume premium outlays.⁶

Model 582 is a model. The NAIC encourages states to adopt its model laws and says state insurance departments provide the oversight, so the version in force where you sell is the one that governs.⁷ For indexed policies, the NAIC's Actuarial Guideline XLIX-A says it applies to illustrations for policies with indexed credits that are subject to Model 582 and sold on or after December 14, 2020. It limits the policy loan leverage shown in an illustration and requires a side-by-side ledger using an alternate scale.⁸ For policies sold on or after April 1, 2026, it also requires a statement substantially similar to "Historical index changes shown in this illustration are not indicative of future returns."⁸ The NAIC says revisions took effect in 2023 to tighten illustration limits and in 2026 to enhance consumer-protection disclosures.⁷

What do the advertising rules say about calling a policy retirement planning?

Start with the NAIC's advertising model, Model 570, which is also a model and not law until a state adopts it. Its definition of advertisement includes prepared sales talks, presentations and materials for use by insurance producers, and it holds the producer who presented an advertisement responsible alongside the insurer.⁹ Three provisions bear on this topic, each stated in the model:

• An advertisement may not omit material information, or use words or illustrations, with the capacity or tendency to mislead purchasers about "state or federal tax consequences."⁹
• It may not emphasize the investment or tax features of a policy to a degree that would mislead the purchaser to believe the policy is anything other than life insurance.⁹
• It may not use terms such as "retirement plan," "savings plan" or "investment" in a way that could lead a buyer to believe he will receive something other than a policy.⁹

Louisiana's Regulation 60 defines advertisement to include "prepared sales talks, presentations, and material for use by insurance producers"¹⁰ and contains the first two of these in similar words.¹¹ The model's "tax-free" provision is narrower than the phrase agents use: it addresses dividends, which may not be called tax-free unless their tax treatment is fully explained.⁹¹¹ Louisiana's rule also requires nonguaranteed elements to be shown with comparable guaranteed figures at equal prominence in an advertisement.¹¹

What these sources do not show is that any particular tax-free retirement pitch violates a rule. They set conditions: material tax consequences cannot be left out, the policy must not be made to sound like something else, and non-guaranteed figures cannot stand alone. Whether your conversation counts as an advertisement, and what your state requires, is a question for your state's rule and your carrier's compliance team. FINRA's investor page says indexed universal life is generally not considered a security, while variable life and variable universal life are securities that must be registered with the SEC.¹²

What can you say instead of "tax-free retirement"?

Describe the mechanism, then the conditions. A few lines that stay accurate:

• "Policy loans and withdrawals can be treated favorably for taxes in some situations. Whether that applies depends on how this policy is structured and used, and a tax professional should confirm it for you."
• "The illustration shows what happens if today's assumptions hold. The carrier can change them, and the guaranteed column shows the floor."
• "If you borrow against it, the loan has interest and reduces the death benefit and cash value. If the policy ends while a loan is open, there can be a tax cost."
• "How much you put in during the first seven years can change how the policy is taxed. I will ask the carrier to run that test before you fund it."
• "I am not able to give tax advice. Here is what I would bring to your tax professional."

Then ask what the client is actually trying to do. For some, the answer is retirement income and the policy is one piece of a plan. For others the need is protection for a spouse or a business, and a policy built for maximum cash accumulation is the wrong tool.

What should stay out of the pitch, and what should the file show?

Keep out any line that promises or implies a result: "tax-free income for life," "no risk to your principal," "like a Roth without limits," or an illustrated income figure presented as what the client will receive. Do not point only to the best column of an illustration, or describe the policy as a retirement account or savings plan.

The model's own mechanics suggest what a file should hold. A signed copy of the illustration goes to the insurer with the application and to the applicant, and if no illustration was used, the agent and applicant sign a form saying so.⁶ Beyond that, these are practical suggestions, not legal requirements: keep a dated note of the structure discussed, the guaranteed and non-guaranteed figures you went through, that you raised lapse, loans and the MEC test, and that you referred the tax question to the client's tax professional. The habits in Documentation Habits That Protect Agents in a Compliance Review apply directly: write the note the same day, and record what you said aloud.

A permanent policy can be a sound part of a retirement plan, and you can say so without the phrase that promises more than the contract does. The test of a good description is whether it would still be accurate on the day the client sits down with a tax professional and the carrier's annual statement.