What Is a Tax-Free Retirement Account (TFRA)?

A tax-free retirement account or TFRA normally refers to permanent cash-value insurance policies that offer risk protection and tax benefits to individuals. A TFRA retirement account is not a qualified plan, so it doesn’t follow the same rules as a 401(k). But it can offer both tax benefits and risk protection for investors. Breaking down how a tax-free retirement account works can help you to decide if this strategy may be right for you. A financial advisor may also be able to help you determine if a TFRA is right for you. Try using SmartAsset’s free advisor matching tool today.

Tax-free retirement accounts can be an indexed universal life insurance policy, variable life policy or a whole life insurance policy. They are covered under Section 7702 of the Internal Revenue Code that is designed to provide tax-free income for retirement. As such, you might hear a TFRA described as a Section 7702 plan.

Financial advisors and wealth managers can market these plans to investors who are looking for an alternative way to save for retirement, beyond a 401(k), pension or individual retirement account (IRA). But it’s important to understand that technically, they’re not retirement accounts at all. Instead, these are qualified life insurance contracts that can be used to generate tax-free income for retirement.

How Does a TFRA Work?

A tax-free retirement account or Section 7702 plan is funded through a permanent cash value life insurance policy. A TFRA is funded with after-tax dollars, similar to the way you’d fund a Roth IRA. Cash value in the policy grows tax-deferred and policy owners can take out tax-free loans from that cash value during their lifetime. The amount of cash value that accrues inside the policy can depend on the underlying investment strategy.

Since TFRAs are not qualified plans, they’re not subject to the same tax rules as those plans. Instead, this is a retirement account where investments are tax-exempt. For example, there’s no 10% early withdrawal penalty to worry about if you need to take funds out of the policy prior to age 59 ½ as there would be with a 401(k) or IRA. Income generated by the policy is also tax-free.

TFRA Requirements

TFRAs can be used to plan for retirement alongside other qualified retirement plans but they can’t be commingled. For example, if you’re changing jobs and want to roll over your 401(k), you wouldn’t be able to do a direct rollover to the policy. You could, however, roll the funds over into your new employer’s 401(k) or into an IRA.

Additionally, a TFRA is a long-term investment plan. It is required that you’re able to fund the account for at least three years, at a minimum. You also must let the income grow for seven to 10 years before withdrawing funds from the account.

All rules for TFRA plans are governed by a contract, which is different from some plans like 401(k)s or 403(b) plans, which rules are governed by Congress.

Advantages of a TFRA Retirement Account

Income from Section 7702 plans is tax-free and the principal is not taxable either. With a 401(k), on the other hand, you’d eventually have to pay taxes on earnings once you begin making qualified withdrawals in retirement. A TFRA can also offer greater liquidity since you can access cash value as needed without triggering any type of tax penalty.

Tax-free retirement accounts can also be useful for generating an additional stream of income for retirement. The level of returns you see can depend on the underlying investment strategy. Again, policies can utilize whole life, variable life or universal life strategies, each of which has a different risk/reward profile.

Finally, it’s important to remember that this is life insurance. So that means that once you pass away, your policy beneficiaries will be able to collect the death benefit. Your policy may also include a rider allowing you to take accelerated death benefits to pay for end-of-life care. Keep in mind that taking accelerated benefits or a loan from the policy that is not repaid can reduce the death benefit payable to the beneficiaries.

Is a TFRA Better than a Roth IRA?

A TFRA has certain advantages over a Roth IRA. There are no federal regulations about withdrawals with a TFRA, unlike a Roth IRA, which must be held for five years before beginning to take distributions from it. Further, with a TFRA comes with what is known as a “floor.” TFRA funds are indexed to the market – not in the market. As a result, when the market gains your TFRA gains; if the market declines, your TFRA does not decline.

In addition, TFRA accounts offer benefits for people with critical, chronic and terminal illnesses. They also have a permanent death benefit, which begins on the first day the plan is in effect. Unlike qualified retirement plans, a TFRA does not limit contributions. It must, however, adhere to the rules and laws of life insurance.

Disadvantages of TFRAs

Tax-free income sounds good, but it’s important to consider what you’re getting for your money. Cash-value life insurance policies tend to be more expensive than term life insurance. That’s because the policy is designed to cover you for life so there’s a much greater chance of the insurance company will have to pay out a death benefit.

In addition to the premiums involved, these policies may come with management fees or administrative fees, including agent commissions. Depending on the type of policy and the amount of coverage, this commission can end up being quite steep.

You won’t escape fees with a 401(k) or IRA as there can still be management fees and other expenses. But you may not be paying commission fees to invest in them. And in terms of performance, you might see higher returns with investments held in a qualified plan. So it’s helpful to weigh what you might pay against the potential returns and income you could generate.

How to Open a TFRA

If you’re interested in using a TFRA as part of your retirement planning strategy, you can talk to your financial advisor or insurance agent about possible options. These plans do have certain guidelines they need to follow under Section 7702 so this typically isn’t something you can try to set up on your own.

A financial advisor can review your overall financial situation to determine:

What your tax liability in retirement might be, based on the income your current retirement accounts are set to generate
How much income could be created using a tax-free retirement account
What tax benefits you’d realize from utilizing a TFRA

You can also discuss how much life insurance you might need and whether paying more for a permanent policy versus term life coverage makes sense.

Who Should Consider a TFRA?

A TFRA may be attractive to someone that is highly risk averse and, even with a very conservative asset allocation in a portfolio, needs some secure to sleep well at night.

Another type of person would could benefit from a TFRA is someone who earns too much money to qualify for a Roth IRA.

Finally, someone who is already contributing the maximum to his or her 401(k) account should consider a TFRA.

Bottom Line

A TFRA retirement account is a lesser-known strategy for long-term financial planning, but it’s something you may want to consider if you’re interested in tax-free income. If you have access to a 401(k) at work or an IRA, you can also use those accounts to save money for retirement on a tax-advantaged basis. The more income streams you can create, whether it’s through qualified plans, a TFRA, an annuity or something else, the more secure your retirement may be.

Retirement Planning Tips

Consider talking to a financial advisor in more detail about tax-free retirement accounts and whether one might be right for you. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
When contributing to tax-advantaged plans, be aware of annual contribution limits. With a TFRA retirement account, no such maximum exists. But the IRS does cap how much you can save in a 401(k) or IRA each year. Being mindful of the annual limits for contributions to each type of plan can help you develop a strategy for maxing out your retirement accounts.