Can Your IRA Take the Place of Life Insurance?

It can, to some extent. But there are rules you'll need to follow.

Many people sock money away in an IRA account year after year so they're able to retire with a nice nest egg. If you started funding your IRA in your early 20s and you're now, say, in your 40s, you may have a nice sum of cash to your name. And if you want to make sure your loved ones are protected financially in your absence, you may also be thinking about buying life insurance if you don't have a policy already.

But do you need one? Let's say you're thinking of purchasing a life insurance policy worth $500,000, but you have a $500,000 balance in your IRA. Will an inherited IRA suffice for your loved ones? Or do you need life insurance as well?

Your survivors could get more money with life insurance

The rules of inherited IRAs can be very complicated. So can the rules of life insurance payouts. But generally speaking, if you put life insurance in place and pass away, your beneficiaries will be entitled to a payout that's free of taxes. That may not be the case with an inherited IRA.

If you have your money in a traditional IRA and your beneficiaries inherit it upon your passing, they'll generally be subject to taxes on that money. So, let's say you want to leave your loved ones with $500,000 upon your death. If you buy a life insurance policy with that death benefit, your loved ones should actually walk away with $500,000 if you pass away while your coverage is still in place. With a $500,000 IRA, they might only end up with, say, $370,000 after taxes are accounted for.

Now the rules are different with a Roth IRA. Roth IRAs don't give you a tax break on contributions like traditional IRAs do. But one benefit of Roth IRAs is that you get to enjoy tax-free withdrawals in retirement.

If you don't make it to retirement, but rather, pass away before that milestone arrives and leave your Roth IRA to your loved ones, they should be entitled to that money tax-free. But falling back on a traditional IRA instead of life insurance could leave your beneficiaries with less money upon your passing.

Make the right call

It's easy to see why you might think a giant IRA balance can take the place of life insurance. But remember, the two have totally separate purposes.

The point of an IRA is to serve as an income source for you during retirement. The point of life insurance is to protect your loved ones if you pass away at a time when you're still providing them with financial support. It's better to keep those two concepts separate -- and buy life insurance even if you're doing a great job of consistently funding your IRA.

Remember, too, that if you pass away and leave your loved ones with a large IRA to inherit as well as a generous life insurance payout, you'll only be giving them that much more protection. So if you can swing the cost of a life insurance policy, it pays to get one.