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) or similar workplace account. 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 can help you determine if a TFRA is right for you, or you can work with them to create a full retirement plan.

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

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, and are 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-deferred.

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 of 401(k) assets 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 the laws of Congress.

Advantages of a TFRA Retirement Account

Tax-free retirement accounts, or Section 7702 plans, offer unique benefits that differentiate them from traditional retirement savings vehicles like 401(k)s and IRAs. These plans provide tax advantages, financial flexibility, and additional protections that can enhance retirement planning. Here are some of the primary advantages and benefits of TFRAs:

• Tax-free income and principal: Earnings are tax-deferred, and withdrawals of principal from a TFRA are not subject to income tax, unlike traditional retirement accounts, where the entire withdrawal is taxes as ordinary income
• Greater liquidity: Unlike 401(k)s and IRAs, which impose penalties for early withdrawals, a TFRA allows policyholders to access cash value without triggering tax penalties.
• Potential for additional income streams: Depending on the investment strategy, a TFRA can generate returns through whole life, variable life or universal life policies, each offering different levels of risk and reward.
• Life insurance benefits: As a life insurance-based vehicle, a TFRA provides a death benefit to beneficiaries, ensuring financial security for loved ones.
• End-of-life care options: Many policies include riders for accelerated death benefits, allowing policyholders to access funds to cover medical or long-term care expenses. However, unpaid loans or withdrawals can reduce the death benefit.

Estimate how lowering your taxable income through retirement contributions could change your overall tax liability.

TRFA vs. Roth IRA

While both TFRAs and Roth IRA accounts provide tax-free benefits, a Roth IRA is generally more cost-effective for retirement savings, whereas a TFRA offers additional life insurance protections.

A TFRA and a Roth IRA handle withdrawals differently. Both allow you to access contributions without tax or penalty before five years, but the Roth’s five-year rule applies only to earning withdrawals. After that period, qualified Roth withdrawals can be fully tax-free, which gives the Roth a stronger long-term advantage. In contrast, cash value from a TFRA can generally be accessed through loans or withdrawals, but only contributions, not gains, can be taken out tax-free.

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. However, Roth IRAs provide direct exposure to stocks, bonds and other market assets, potentially leading to higher investment returns.

On the other hand, 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

While tax-free income and other benefits make TFRAs appealing, they also come with costs and trade-offs. Understanding these potential drawbacks can help determine whether a TFRA aligns with your financial goals. Here are some key disadvantages to consider:

• Higher premium costs: Cash-value life insurance policies, which fund TFRAs, tend to be more expensive than term life insurance since they provide lifelong coverage, increasing the likelihood of a payout.
• Additional fees and commissions: Policies may include management fees, administrative charges, and agent commissions, which can be significant depending on the coverage amount and policy type.
• Potentially lower investment returns: While TFRAs offer tax advantages, traditional retirement accounts like 401(k)s and IRAs may provide higher returns through diversified market investments.
• Opportunity cost: The money allocated to a TFRA might generate better long-term returns if invested in traditional retirement accounts or other market-based assets.

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 Tax-Free Retirement Account (TFRA) may appeal to individuals looking for flexible, tax-advantaged ways to build long-term wealth outside of traditional retirement plans. These accounts are often structured using permanent life insurance policies that allow contributions to grow tax-deferred and be accessed tax-free if managed properly. Because they don’t have IRS contribution limits or required minimum distributions, TFRAs can be attractive to high earners who have already maxed out their 401(k) or IRA contributions and want additional tax-efficient growth.

They may also be a fit for people who value liquidity and financial flexibility. Unlike many retirement accounts, TFRAs allow you to access accumulated cash value at any time without penalties, which can be helpful for major expenses or financial emergencies.

However, these accounts come with costs and complexities, making them less ideal for individuals who are just starting to save or who need a simple, low-cost retirement vehicle. Before opening a TFRA, it’s wise to speak with a financial advisor who can help determine whether it aligns with your goals, risk tolerance and broader financial plan.

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-deferred 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 vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel 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.

Photo credit: ©iStock.com/katleho Seisa, ©iStock.com/Tinpixels, ©iStock.com/PeopleImages