It is estimated that over 50% of American adults have life insurance. The major advantage of life insurance is that it can provide your heirs with tax-free financial security. However, should more Americans be considering the Self-Directed Roth IRA vs. life insurance as a more flexible and cheaper alternative to life insurance? This article will explore the tax advantages of the Roth IRA and detail why focusing on growing one’s plan could end up providing your heirs with financial stability while also providing you with more financial flexibility during your life.

What is a Roth IRA?

The Roth IRA was created by the late Senator Roth of Delaware in 1997, and is an after-tax IRA, which, unlike a traditional IRA, does not offer an immediate tax deduction to the IRA holder. However, so long as any Roth is open for at least five years and the Roth holder is over the age of 59 1/2, all distributions are tax free. As an extra incentive, there are no required minimum distributions for Roth IRAs so you can let the account grow for as long as you like.

Who is eligible for a Roth IRA?

The maximum Roth IRA contribution for 2023 is $6,500 or $7,500 if at least age 50. In order to make a contribution, one must have sufficient earned income. Earned income is income generated from the performance of services or business income. However, the Roth IRA rules imposes income limitations on who can make Roth contributions. If one has annual income above $153,000 (single) or $228,000 (married) then Roth IRA contributions are not allowed. However, there is a work-around known as the “Backdoor Roth IRA.”  If one earns too much to directly contribute to a Roth, the backdoor will allow them to still make contributions. This is a result of a 2010 law that ended the income limitations for Roth conversions to generate additional tax revenues for the Treasury. You can contribute after-tax funds to a traditional IRA, and then convert those to Roth.

In sum, anyone with sufficient earned (non-passive) income can contribute to a Roth IRA, no matter what your annual income is. Of course, you can only contribute up to the annual limit, or the amount of income earned in the year, whichever is less.

Leaving a Roth IRA to an Heir

If you are a beneficiary of a Roth IRA from a spouse, the IRS allows you to treat the plan and its assets as if they were always yours. The Roth, which will now be in your name, receives the same tax treatment as the original IRA owner. Because the money contributed to the Roth was on an after-tax basis, the spousal beneficiary can take a distribution without paying tax or penalty once you reach age 59 1/2. You would be given a source of tax-free wealth. However, for non-spousal beneficiaries, different rules apply.

The SECURE Act, which went into effect in 2020, changed the Inherited IRA rules for non-spouse beneficiaries. If your loved one died before Dec. 31, 2019, the old rules apply, which means you would be able to take tax-free distributions over your lifetime, based off a life expectancy table released by the IRS. However, under the SECURE Act, If the Roth IRA owner passed in 2020 or later, the non-spousal beneficiary of the Roth IRA would need to take required minimum distributions (RMDs) of the entire amount of the plan within ten years.

In both cases, all Roth IRA distributions would be tax-free, but would be part of the deceased’s estate for purposes of estate tax, if applicable.

Life Insurance Basics

We all know what life insurance is, however, some do not fully comprehend the tax benefits of it. In general, life insurance death benefit payouts are generally tax-free to the beneficiaries of the policy. In addition, whole life insurance contains a central savings feature known as cash value that allows the policy holder to take out funds or borrow against the policy without tax. However, there are some disadvantages of choosing life insurance.

First, the premiums could be costly depending on your age and health condition. Next, in the case of term and other policies, the policy could lapse with no death benefit payout. Thirdly, in the case of some policies, the returns offered are significantly lower than standalone investment instruments. Finally, in the case of term life insurance, failure to timely pay premiums will result in the policy lapsing and your beneficiaries will likely not be able to claim your death benefit, plus you’ll lose the premiums you’ve already paid.

The Self-Directed Roth IRA Solution

The Self-Directed Roth IRA solution allows one to invest his or her Roth IRA into almost any alternative asset, such as real estate, private businesses, investment funds, gold, cryptos, and much more. Other than life insurance, collectibles, and certain self-dealing transactions, self-directing your plan will allow one to invest in assets they know and trust and properly diversify his or her retirement holdings. 

There are two ways to fund a Self-Directed Roth IRA: (i) annual contributions or (ii) rollover from another IRA or 401(k) plan. Roth contributions can be taken out tax-free at anytime, however, earnings can only be taken out tax-free once the IRA owner reaches the age of 59 1/2 and the Roth has been opened at least five years. Of course, you can leave the plan to a beneficiary when you pass, and it would be subject to the same rules as above.

Self-Directed Roth IRA vs. Life Insurance

Both life insurance and the Self-Directed Roth IRA offer their beneficiaries tax-free access to either the death benefit or the Roth IRA funds. Both life insurance and the Roth IRA have enormous tax and estate planning benefits, and many smart savers tend to combine both in their savings strategy. However, the following table will provide an overview and compare some of the advantages and disadvantages of the two options:

	Tax Advantages	Flexibility	Largest Death Benefit	Guaranteed Death Benefit
Life Insurance	Tax-free death benefits	Term insurance provides for lower premiums but limits on death benefits. Whole life insurance has high premiums but offers cash value and loan features.	Life insurance allows one to pay high premiums to get a guaranteed death benefit. Hence, for high income earners life insurance has a big death benefit advantage.	Term life will not provide a guaranteed death benefit if you out live the policy, but other life insurance policies will. However, those policies typically come with high annual premium requirements.
Self-Directed Roth IRA	Tax-free life benefits if over the age of 59 1/2 and Roth IRA opened at least five years.  Tax-free death benefits to Roth IRA beneficiaries over the course of ten years.	Roth IRA contributions are 100% elective and are limited to the annual limits set by the IRS.	Roth IRA offers more flexibility in annual contributions, but the annual limit would also limit death benefits for high income earners.	Whatever is in the Roth IRA can be left tax-free to your beneficiaries. There is no guaranteed death benefit amount, but there is also no risk the account will lapse.

Putting it All Together

Both the Self-Directed Roth IRA and life insurance are valuable saving and estate planning solutions.  Both have advantages (and some disadvantages), but in combination complement each other remarkably well.

For someone just looking for some death benefit protection, term life insurance is a great solution.  Premiums are quite inexpensive, and the product offers guaranteed death benefits during the period of the term life insurance policy. Whereas someone looking for more cash value and longer-term death benefits, whole life insurance may be a better option. The Roth IRA solution offers flexibility in terms of annual contribution requirements, although, the death benefit is not guaranteed.  Hence, for most Americans, a combination of some sort of term life insurance with a Roth IRA makes the most sense from a tax savings and legacy estate planning standpoint.