One of the key attributes of cash value life insurance is the ability to build reserves of cash within the policy. However, most people don’t really understand the various ways that cash can accumulate within a permanent life insurance policy OR the pros and cons of using life insurance for cash accumulation.
Among the various types of permanent life insurance, cash can actually accumulate in a number of different ways based upon the policy and the strategy chosen. The pros and cons of using life insurance for cash value accumulation also vary based upon the policy type and strategy you use. This article is a walk through of these topics in hope of shedding some light on this confusing area.
Financial entertainers who profit from market based investments often “poo poo” life insurance by insisting that it isn’t an “investment”. To these folks, apparently throwing your chips into the stock market constitutes prudent “investing”. More difficult to swallow, is the suggestion that “saving” your money in a traditional bank constitutes wise financial planning. I suggest that these kinds of assertions are part of a “turf war” between life insurance and that stock market and thus all such overgeneralized claims deserve careful scrutiny.
How Cash Value Accumulates in a Life Insurance Policy
- Market Based Accumulation (Indexed Universal and Variable Universal Policies)
- Guaranteed Accumulation (Whole Life Policies and Possibly Guaranteed Universal Policies)
The genre of permanent life insurance known as universal life insurance offers a few different types of growth depending upon the formula selected. Amount this category of life insurance are the subcategories of:
A fourth lesser known category, that is really a spin off of variable universal life is called private placement life insurance. Private placement life is typically reserved for the wealthy due to high costs, risks and investor restrictions.
Cash Accumulation with Guaranteed Universal Life
The cash accumulation in a guaranteed universal life (GUL) policy is usually minimal. These policies are typically selected to secure a permanent death benefit rather than for cash value accumulation.
Although these policies can offer some cash accumulation over the life of the policy, borrowing against this cash, as discussed more below, could reduce or even eliminate the death benefit, cause the policy to lapse, or both. Thus, other life insurance products are more appropriate for cash value accumulation strategies.
Cash Value Accumulation with Indexed Universal Life
In an indexed universal life policy (IUL), premiums are added to the cash value after subtracting for the cost of the death benefit and fees. The cash value is credited with an interest rate of return based upon increases in an “equity index” but is NOT invested directly in the financial markets.
Most IULs offer a minimum guaranteed interest rate (i.e. floor) and a choice of indexes, such as the S&P 500 and the NASDAQ 100. The policy holder can select the CASH VALUE percentage allocated to each index.
When calculating the return, the value of the selected index is recorded at the beginning of the month and compared to the value at the end of the month. The gains are credited to the policy usually on an monthly or annual basis, depending on the policy and carrier.
Cash Accumulation with Variable Universal Life
Because of investment risks, variable universal life (VUL) policies are regulated by the securities and exchange commission and are marketed like other securities. VUL policies can participate directly in market gains (and also losses).
Typically, a portion of the premiums in a VUL policy is allocated to a separate account comprised of investment funds such as stocks, bonds, equity funds, money market funds, and bond funds. The downside of the VUL structure is that these policies are generally viewed as more unstable and additional premiums may be required in order to make sure that the policy does not lapse and the death benefit remains in place until a certain age.
Traditional whole life insurance policies can be evaluated based upon both a ‘”guaranteed” and “non-guaranteed” rate of return.
The non-guaranteed portion is typically very conservative and may range from 2 – 4% per year. The guaranteed rate of return in a whole life policy is not impacted by market risks, etc, and thus may constitute a “safe bucket” for cash reserves. Premiums with whole life policies are generally “fixed”.
On one hand, these policies lack the flexibility of IUL and VUL policies. On the other hand, these policies do NOT need to be as a actively managed or contributed to down the road to make sure that the death benefit stays in place.
A disadvantage to a whole life policy is that these are “front end loaded,” which means that up front costs are expensive.
So, if you’re not sure about being able to manage the premiums for a few years, perhaps this isn’t the best route. Alternatively, you may want to consider limited pay life insurance.
In the long term, many infinite banking practitioners suggest that whole life is far superior for cash value accumulation and usage because of the stability and predictability of the policy; and, we haven’t talked about dividends yet.
If a life insurance company or policy is referred to as “participating“, it means that the policy holder is actively participating in the funding of the policy. As a “participant”, the policy holder is then entitled to receive “dividends” which are a portion of profits that are received by the company.
Better yet, dividends paid that do not exceed the total amount of premiums paid into the policy are viewed, by the IRS, as a return of those premiums and NOT taxable income.
Thus dividends offer one of the key tax advantages of whole life insurance when it comes to cash accumulation.
This “return of premium”” in the forms of dividends is an important characteristic of dividend paying mutual life insurance companies such as Mass Mutual and Penn Mutual (as opposed to a stock life insurance company such as Metlife).
Direct and Non-Direct Recognition Policy Loans
An important factor when using life insurance for cash accumulation concerns the ability to take policy loans, secured by the cash value, without actually withdrawing the cash. This is discussed more completely in our article discussing direct recognition vs non-direct recognition.
Borrowing money from the carrier using the policy’s cash value as collateral is a key part of using an infinite banking strategy because it avoids tax consequences, since loans do not constitute income.
Also, with most solid infinite banking insurance companies, and particularly non-direct recognition companies, the cash value growth is NOT affected by the outstanding life insurance policy loans. This means that you could borrow 100% of the cash value, and the guaranteed return on the cash as well as the dividends will continue.
Earning your full interest and dividend, while a loan is outstanding, is an important part of creating a financial arbitrage and capitalizing on the velocity of money, both which are key aspects of the infinite banking concept®. The ability to take policy loans is also an attractive feature when the plan is to utilize life insurance policy proceeds for investing in real estate and other income producing assets.
Policy Loan vs HELOC
I often compare life insurance to real estate when talking about loans because taking a policy loan is similar to taking a line of credit against real estate EXCEPT that the loan process requires no approval. All you have to do is request a loan from the insurance company. Since you are first in line for your policy’s cash value, you are guaranteed the ability to borrow with no questions asked.
Another way a life insurance loan is superior to a home equity line of credit is that the loan can occur in a few short days rather than having to wait weeks or months.
Tax Benefits and Cash Value Accumulation
Continuous Compounding Growth
One of the key attributes of permanent life insurance and especially participating whole life policies is the tax advantages.
For both universal life and whole life policies, cash value accumulates in a tax deferred environment, which means that no taxes on gain are realized until cash is withdrawn (above your basis) from the policy. This important detail is often missed by the critics and it is a HUGE benefit because the cash can continuously compound within the policy tax free, in contrast to a mutual fund where anytime you sell a position it must be reported on your tax return.
This may seem like a minor benefit but I can assure you it is not. Let’s use the analogy of the “penny a day doubled” WITHOUT and WITH capital gains taxes:
Pretty amazing, right? Who knew that doubling a penny a day could result in such a huge return. But look at the difference when you factor in taxes. The non taxed account grew 100 times larger in the same time frame.
Tax Free Dividends
Adding to the power of tax free accumulation of cash value in IUL and VUL policies, a participating whole life policy adds tax free dividend payments to the equation.
So not only will the cash accumulate at guaranteed rates tax free, but dividends and reliable non-guaranteed historically documented returns can enhance accumulation in these policies.
This overview of cash accumulation is general but hopefully will serve you as a guide when considering the type of policy and strategy that makes sense for you.
If you have more questions about cash value accumulation or anything related to life insurance or estate planning, please reach out to us today.