The Many Benefits of Cash Value Life Insurance
Generating tax-free cash flow with a proven and reliable asset
Although life insurance is oftentimes purchased for the death benefit it provides, there are actually many ways that this flexible financial vehicle can be used – and no one has to die in order to receive monetary benefits.
In fact, with a properly structured cash value life insurance policy, you could obtain a long list of advantages, including tax-free access to funds – either in installments or a single lump sum – as well as financial protection for your loved ones…just in case.
But not all cash value life insurance policies are exactly the same – and without the right features in place, you may find that the benefits you had hoped to attain are not available. With that in mind, the first step towards maximizing your tax deferred savings and tax-free income is understanding whether or not cash value life insurance is the right strategy for you. That is exactly what this guide will show you how to do.
Why Life Insurance Isn’t Purchased Just for the Death Benefit Anymore
If you are in the process of saving and planning for retirement, you may not consider life insurance as an integral part of your overall strategy. This is particularly the case if you have no dependents who could suffer financial hardship if you pass away unexpectedly.
In the past, many people purchased life insurance for just one reason. They would pay the premium, and the death benefit would be paid out to the beneficiary(ies) if the insured died while the policy was still in force.
But things have changed.
Over the last couple of decades, life insurance companies have come up with a wide variety of products that allow investors and retirees to take advantage of life insurance without anyone having to die in order to do so.
For instance, these life insurance “living benefits” can provide the policy holder with access to money while they are alive for any number of needs and wants, such as:
- Paying for long-term care services (in a facility or at home)
- Generating tax deferred savings
- Paying for care that is needed as a result of a chronic or terminal illness
- Supplementing retirement income (in some cases, tax-free)
- Accessing a lump sum of cash (also tax-free, if properly structured)
How Life Insurance Works
While there are many different ways that life insurance can be structured, there are just two primary categories of this type of coverage. These are term and permanent. Knowing the difference between these two life insurance types is essential for determining whether or not they could work for you.
Term Life Insurance
Term life insurance provides only death benefit coverage, with no cash value or investment build-up. These policies will typically remain in force for a stated period of time (or “term”), such as 10 or 20 years – as long as the premium is paid.
A term policy will oftentimes require less premium than a permanent policy with the same amount of death benefit. This is particularly so if the insured is young and in relatively good health at the time they apply for the coverage.
If a term life insurance policy expires, the insured may have to renew the coverage in order to keep it in force, based on their then-current age and health condition. Because of that, the premium going forward is likely to increase, due in large part to the insured’s older age.
It is also possible that an insured won’t qualify to obtain new coverage at all, if they have acquired certain health-related conditions that could deem them a higher risk to the insurer.
Term life insurance is often used for covering “temporary” needs. For instance, if you (and your spouse, if applicable) purchase a home and you have a 15-year mortgage, you could each buy a 15-year term life insurance policy that would cover the loan balance if one of you passes away.
That way, the surviving spouse could pay off the mortgage and not have to drastically change their lifestyle by moving to a more affordable living arrangement if the amount of household income drops substantially.
Some term life insurance policies may be “converted” over into a permanent form of coverage. Depending on the policy, the insured may not have to provide evidence of insurability in order to take advantage of this benefit.
Pros and Cons of Term Life Insurance
|Term Life Insurance Advantages||Term Life Insurance Disadvantages|
|Premium is oftentimes low (at least in the early years of the policy)||Coverage expires|
|Death benefit is income tax free||No cash value build-up|
|May be converted to permanent coverage||The insured needs to qualify for coverage (and if so, the amount of the premium could be considerably higher going forward)|
Permanent / Cash Value Life Insurance
Permanent life insurance provides death benefit protection, as well as a cash value account. The funds that are in the cash value account grow tax-deferred, meaning that no tax is due on the gain unless or until the money is withdrawn.
Tax Deferred versus Fully Taxable Growth
This tax deferral can help the value in the cash value account to grow and compound exponentially – especially as compared to a fully taxable account, with all other factors being equal. However, unlike other tax-favored financial vehicles – such as traditional IRAs and retirement plans – permanent life insurance does not require you to start accessing funds when you reach age 72, regardless of whether or not you need the money at that time.
Likewise, many types of retirement plans and IRAs can also impose a 10% “early withdrawal” penalty if you access funds before you have reached age 59 ½. The 10% IRS early withdrawal charge is in addition to any taxes that you may owe on cash value withdrawals. But this is not the case with cash value life insurance.
It is important to note, though, that there may still be an early surrender charge that is imposed by the life insurance company if you make withdrawals prior to the end of the surrender period. However, taking out a life insurance loan will allow you access to your cash value account as you use it for collateral to borrow from the insurance company.
There are several different types of permanent life insurance policies available in the marketplace today.
Different Permanent Life Insurance Policies include:
- Whole life insurance
- Universal life insurance
- Variable life insurance
- Indexed universal life insurance
- Variable universal life insurance.
All of these permanent policy types have different methods for generating a return in the cash component. In addition, permanent life insurance coverage will usually remain in force, as long as the premium is paid or if the policy is “paid up.” This can be especially beneficial if the insured has contracted serious health issues and may not otherwise qualify for a new life insurance policy.
Even though the premium on a permanent life insurance policy is typically higher than that of a comparable term insurance policy, the amount of the premium can be locked in and guaranteed not to increase with certain types of permanent policies like whole life insurance (whereas term life insurance premiums can rise significantly as the insured ages, and in turn, becomes a higher risk to the insurer).
It may also be possible to take advantage of certain benefits, referred to as “living benefits,” while the insured is still alive if they have a permanent life insurance policy. This feature can help to more closely “customize” permanent life insurance to your specific short- and long-term financial and insurance objectives.
Pros and Cons of Permanent Life Insurance
|Cash Value Life Insurance Advantages||Cash Value Life Insurance Disadvantages|
|Coverage is permanent (provided that the premium is paid), and may be guaranteed not to increase with certain types of policies||Premium is often higher than a term life insurance policy with the same amount of death benefit coverage (at least in the early years)|
|Cash / savings component||Surrender charges (for a set period of time)|
|Growth in the cash component is tax deferred||Interest rate on cash value growth is usually low|
|May include "living benefits" for illness, long-term care services, and/or other needs||The gain on cash value withdrawals is typically taxable|
|No annual maximum contribution limits|
|Cash value may be withdrawn and / or borrowed (in the latter case, tax-free)|
|No required minimum distribution (RMD) rule for accessing the policy's cash value at age 72|
|No IRS 10% early withdrawal charge if accessing cash prior to age 59 ½|
High Cash Value Life Insurance
Within each of the life insurance categories, there are numerous policy configurations available. The way that a permanent life insurance policy is structured can help with determining how the return is calculated.
A policy’s structure can also allow you to use the coverage and the funds in the cash component in beneficial ways. For instance, high cash value life insurance could provide you with a way to supplement retirement income on a tax-free basis.
In this case, if you take money out of a properly structured life insurance policy though a loan, the distribution is considered tax-free. This is because the IRS does not consider life insurance loans to be taxable income. Tax-free access to funds means that you have use of 100% of the money that you borrow – without having to hand over a portion of it to Uncle Sam.
Further, because you are technically borrowing the money from the life insurance company (versus from the actual policy), all of the money in the cash value account can continue to receive interest. For example, if you have $80,000 in cash value, and you take a $30,000 policy loan, your policy’s cash value account will continue to generate interest on the $80,000.
With that in mind, even though life insurance companies typically charge interest on the unpaid policy loan balance, because your cash value is also continuing to earn interest, it is possible that the interest will be a “wash.” In other words, it is possible that the amount of interest you generate could “balance out” the amount of interest that you owe.
It is important to keep in mind that, even though these types of loans are not required to be paid back, interest will still accrue. In addition, if you don’t have at least some funds left in your policy’s cash value account when you (the insured) pass away, then the policy will lose its tax-free protection and as a result, all of the taxes that you were able to avoid will come due in that year.
Overfunded Life Insurance
How can certain permanent life insurance policies generate so much cash value that can be used to supplement retirement income, pay off higher-interest debt, or any other need that you have?
One way is to “overfund” the policy. Overfunded life insurance happens when you pay more into a policy than is required to keep it in force. In doing so, you are essentially contributing only the required minimum to fund the insurance, and putting more into the cash value account.
Policy holders typically need to pay a certain amount of premium to keep the plan in force. Doing so can ensure that the beneficiary(ies) will receive the death benefit when the insured passes away. However, paying more than the minimum amount of premium that is required allows the funds in the cash value account to grow.
While the IRS does not set a yearly maximum limit on how much you can contribute to a life insurance policy, it is important that you keep the premium payments within certain guidelines so that the policy does not lose its tax advantaged status. Working with a life insurance specialist can help you to properly set up and fund your plan.
Life Insurance Cash Value vs. Death Benefit
Permanent life insurance is unlike any other asset that is available in the marketplace. That is because it can offer the combination of a tax-free death benefit and financial protection for your loved ones, along with tax-favored access to the cash value during your lifetime.
The cash value in a life insurance policy differs from its death benefit, though. For instance, the cash value is a savings that accumulates over time, while the death benefit is the amount of money that the named beneficiary(ies) will receive upon the insured’s death. If the policy holder cancels a permanent life insurance, they will generally receive the accrued cash value – and any of these funds that are considered gain will be taxable.
In some ways, a cash value policy can offer you a “best of both” worlds scenario, because you can generate tax deferred growth and tax-free withdrawals, while also making sure that your loved ones are protected financially with a pre-set amount of proceeds.
In addition, depending on your state laws, life insurance proceeds could also receive favorable protection from creditors – which includes bankruptcy. This can be particularly beneficial if you are a small business owner, doctor, attorney, or other professional that may incur higher liability risk.
Permanent Life Insurance vs Other Financial Accounts
|Cash Value Life Insurance||Taxable Investments||Qualified Plans / Traditional IRAs||Roth IRAs||Municipal Bonds|
|Tax-Favored Access to Funds||Yes||No||No||Yes||Yes|
|Annual Maximum Contribution Limit||No||No||Yes||Yes||No|
|No Mandatory Withdrawals||Yes||Yes||No||Yes||Yes|
|Tax Deferred Accumulation||Yes||No||Yes||Yes||Yes|
|Income Tax-Free Death Benefit||Yes||No||No||No||No|
|No Tax Penalties for "Early Withdrawals"*||Yes||Yes||No||No||Yes|
|Cost of Insurance Charges||Yes||No||No||No||No|
**No market risk on whole life and indexed universal life insurance cash values. Variable life insurance can be subject to market risk.
How to Enhance Your Cash Flow Using a Permanent Life Insurance Plan
Permanent life insurance policies can enhance your cash flow, in turn, supplementing retirement income and allowing you more to use towards paying expenses in the future. There are different methods you can use to access funds from a cash value policy, though.
When you withdraw money from a permanent life insurance policy, you will be taxed on the portion of the money that is considered gain. The amount that you are taxed will correspond with your then-current income tax rate and bracket.
Federal Income Tax Rates in 2023
|Tax Rate %||Single||Married Filing Jointly||Head of Household|
|10%||Up to $11,000||Up to $22,000||Up to $15,700|
|12%||$11,001 to $44,725||$22,001 to $89,450||$15,701 to $59,850|
|22%||$44,726 to $95,375||$89,451 to $190,750||$59,851 to $95,350|
|24%||$95,376 to $182,100||$190,751 to $364,200||$95,351 to $182,100|
|32%||$182,101 to $231,250||$364,201 to $462,500||$182,101 to $231,250|
|35%||$231,251 to $578,125||$462,501 to $693,750||$231,251 to $578,100|
|37%||Over $578,125||Over $693,750||Over $578,100|
In addition, you may also incur an early withdrawal, or “surrender” charge. A policy’s surrender period typically lasts for several years. The amount of the surrender charge – which is stated as a percentage of the withdrawal – will generally decrease over time until it disappears altogether.
Taking loans from the cash value, however, can provide you with tax advantages – starting with their tax-free status. Because a permanent life policy’s cash value can typically be accessed at any time by the policy holder through withdrawals or policy loans, these financial vehicles could provide you with some additional income in retirement.
As an added bonus, paying back the policy loan is optional. However, any portion of the loan that is not repaid at the time of the insured’s death will be paid using the death benefit proceeds. The remainder of these funds – if any – will then be paid income tax-free to the beneficiary(ies).
Factors to Consider Before Purchasing a High Cash Value Life Insurance Policy
Some of the important factors to consider before you purchase a high cash value life insurance policy include the following:
- Age of the insured
- Health condition
- Prescription medications taken
- Health history and family health history
- Marital status
- Financial / retirement goals
- Outstanding debt
- Living expenses (before and during retirement)
- Anticipated future tax bracket
- Possible future estate taxes due
- Intentions for leaving a legacy and/or charitable donations
- Other life insurance in force
- Taxable versus tax-free future income
- Retirement income sources and amount(s)
Is High Cash Value Life Insurance a Good Fit for Your Financial and Retirement Plan?
For many people, saving for retirement and protecting loved ones financially are two of their top planning goals. But even if you have done an excellent job of setting aside money and growing it, will there be enough for what you need and want?
Adding cash value life insurance to your portfolio could be one of the best financial decisions you make. That is because this flexible financial tool can provide you with tax-free access to cash during (or even before) retirement, as well as offer your loved ones a safety net in case of the unexpected.
But, while cash value life insurance has a long list of enticing advantages, these vehicles can also have many “moving parts” – and if the policy is not properly structured – or if you obtain the wrong type of plan – you could forfeit some or all of the benefits. That’s why discussing your needs and objectives with a life insurance expert before you move forward is essential.
This is where Insurance and Estates comes in!
At Insurance and Estates, we assist our clients with maximizing their retirement income, while at the same time reducing taxes and protecting assets. This, in turn, can provide a financial security blanket for those you love and care about.
One of the ways to accomplish several of these goals with one single plan is with high cash value life insurance. But before you commit to a long-term plan of any kind, it is essential that you first discuss your goals with an experienced life insurance specialist.
So, if you still have questions regarding high cash value life insurance – or if you would like to determine whether or not this financial vehicle would be a good addition to your portfolio – contact Insurance and Estates.