How to Unlock Tax-Free Income in Retirement

The Hidden Retirement Fund You Might Already Own

April 01, 2025

As retirement approaches, federal employees and retirees often look beyond traditional savings like the Thrift Savings Plan (TSP) or FERS annuity for added financial flexibility.

One lesser-known asset you might have at your disposal? The cash value in a permanent life insurance policy.

Understanding how this works—and when to use it—can help you unlock tax-advantaged funds without dipping into your TSP early or disrupting your pension.

What Is Cash Value Life Insurance?

If you own a whole life, universal life, or variable life insurance policy, part of your premium has been building up a cash value component over the years. Unlike term life insurance, these policies serve as both protection and a savings vehicle.

The cash value grows tax-deferred, and once accumulated, it becomes a flexible pool you can access in retirement.

How You Can Use That Cash Value

There are three primary ways to tap into your policy's value—each with different pros and cons:

1. Policy Loans

  • How it works: You borrow against your policy’s cash value—typically at low interest and without credit checks.

  • Pros: No tax liability as long as the policy stays active; doesn’t reduce your credit score.

  • Caution: Unpaid loans plus interest will be subtracted from your death benefit.

Example: Bob, a retired GS-14 with a universal life policy, borrows $30,000 to cover home repairs. He avoids tapping his TSP during a market downturn, but makes sure to pay off the loan over time to protect the policy's value.

2. Withdrawals

  • How it works: Take out a portion of your cash value directly.

  • Pros: Withdrawals up to the total amount of premiums paid are typically tax-free.

  • Caution: Reduces both cash value and death benefit; withdrawals above your basis may be taxed as income.

Example: Lisa, a federal retiree with a whole life policy, withdraws $20,000 (less than her premium contributions) to help a grandchild with college expenses—no taxes owed.

3. Policy Surrender

  • How it works: You cancel the policy and take the remaining cash value (minus fees).

  • Pros: Get full access to your money.

  • Caution: You lose your life insurance coverage. Also, gains above the premiums paid are taxable as income.

Tip: Only surrender a policy if life insurance is no longer needed and other income sources are secure.

Weighing the Pros and Cons

Advantages

Considerations

Tax-deferred growth and potentially tax-free access

Reduced death benefit if not repaid

No early withdrawal penalties like with TSP

Loans or large withdrawals could cause the policy to lapse

Flexible borrowing without credit checks

Surrendering may trigger taxes and ends coverage

Federal-Specific Retirement Integration

For federal employees and retirees, it's important to think holistically:

  • You may already have reliable income from FERS, Social Security, and TSP withdrawals.

  • Accessing cash value could be useful for bridge expenses, long-term care costs, or unexpected emergencies—without disrupting your TSP’s growth or triggering taxable events.

Planning Tip: Use cash value loans during market dips so your TSP or IRAs can recover, then repay once markets rebound.

Final Thought: A Tool, Not a Crutch

Cash value life insurance isn’t a one-size-fits-all solution—but it can be a strategic financial tool if used wisely. Make sure to:

  • Review your policy’s details annually

  • Work with a financial advisor familiar with federal benefits and tax rules

  • Avoid over-leveraging or lapsing your policy accidentally