The conventional way to conceive of life insurance is as a financial failsafe protecting loved ones in the event of untimely death.
In this model, life insurance is a contingent asset—a hedge against a major risk—and its principle purpose is income replacement.
If your family depends on your earning capacity and tragedy strikes, you want sufficient cash available to keep the ship afloat.
This is a serviceable model, particularly for term life, but it overlooks the auxiliary benefits life insurance can offer while you’re still living.
Life Insurance as an Asset
Permanent cash-value policies like whole life and universal life aren’t just contingency contracts that pay out if triggered (though they are that, too)—they are also steadily appreciating financial assets that can serve a host of personal financial goals.
A participating whole life policy, for instance, can double as a retirement-savings vehicle, earning tax-deferred, guaranteed returns with no risk of loss.
Or an indexed universal life policy can let you enjoy the benefits of surging equity markets while buffering the risks should those same markets turn sour.
In either case, the policy’s death benefit is still waiting in the background—just in case.
Term Living Benefits vs Permanent Life Living Benefits
Before we dive in, it’s worth differentiating between the “living benefits” available from some term policies vs whole life insurance.
For the most part, term’s living benefits arise from riders accelerating death benefits (AKA Accelerated Death Benefit Rider) if the insured is diagnosed with a terminal, critical, and/or chronic illness.
If triggered, the term policy pays a portion of the death benefit early, as an advance, and the death benefit (if it ends up being triggered) is reduced accordingly.
Or, with a convertible term life policy, a living benefit comes in the form of a contractual right to convert the coverage to whole or universal life. The policy doesn’t initially have cash value, but, if you make the election before a specified date, you can turn it into cash-value life insurance.
The living benefits provided by a whole life or universal life policy are largely derived from the policy’s cash value, although the accelerated death benefit is also included on most policies.
With each premium payment, cash value grows so that, over time, a policy becomes a valuable financial asset apart from the death benefit.
Although acceleration riders are sometimes included in permanent policies, cash value—and, more importantly, what you can do with it—ends up being the more relevant living benefit for most policyholders.
Living Benefits
Cash value life insurance has many benefits. However, we are focused here on the living benefits of life insurance.
The Top 7 Permanent Life Insurance Living Benefits:
- Cash Value Growth
- Life Insurance Dividends
- Policy Loans
- Retirement Planning
- Asset Based Long Term Care
- Chronic Illness Rider
- Guaranteed Death Benefit for Estate Planning
Cash Value Growth
Each whole or universal life premium payment is divided between the cost of insurance (i.e., the insurance company’s underwriting cost) and cash value.
Cash value builds with each payment and earns interest.
The growth compounds over time so that before long a permanent policy’s cash value exceeds total premiums paid.
A policy that stays in place for 20 or 30 years ends up with a cash value significantly exceeding the premium invested and that may even be larger than the policy’s original death benefit, depending on the terms of the specific policy.
As a savings vehicle, whole life offers cash-value growth that is guaranteed at a fixed rate and tax-deferred.
So, there’s no risk of loss, and you don’t owe any income tax for policy growth until you actually take the money out of the policy.
This allows growth to continue compounding predictably without being reduced for taxes, resulting in considerably larger long-term returns.
Universal life also benefits from tax-deferred growth, but there’s more flexibility as to how it is measured.
Variable policies let the policyholder choose among multiple investment options offered by the insurer, and growth is based on investment performance.
Indexed policies link growth to the performance of an equity index (like the NASDAQ or DOW).
Most indexed policies place a monthly or quarterly cap on growth in exchange for a guaranteed minimum rate of return—so cash value won’t decrease even if the market does.
Life Insurance Dividends
Mutual insurance companies are not like ordinary corporations owned by stockholders.
Instead, the company is formally owned by its policyholders.
And, when you purchase a policy, you acquire a small ownership interest in the company.
Life insurance dividends are a portion of the company’s profits divided among and issued to policyholders, similar to the dividends a corporation pays to its shareholders.
Technically, dividends are paid at the discretion of the company’s directors.
However, many life insurers pay them like clockwork—some have issued policyholder dividends every year for over one hundred years.
Thus, if you purchase a policy from the right company, you can count on receiving regular dividend payments.
When you get a dividend, you have multiple options for using it. You can simply take it in cash and stick the money in your pocket or stuff it in a mattress. Or, you can have the insurer hold it in an interest-bearing account or apply it toward your next premium payment.
The approach recommended by many financial advisers is to invest dividends back into the policy via paid-up additions.
When you do that, the insurer treats the dividend as a paid-in-full premium for supplemental life insurance coverage.
Your policy’s death benefit and cash value increase, and the money from the dividend immediately starts growing like the rest of the cash value.
Invest a few dividends back into the policy, and whole life insurance ends up paying out a death benefit decidedly larger than the policy’s face value when initially purchased.
Policy Loans
Cash value can also serve as security for a policy loan from the insurance company.
In most cases, permanent life insurance policies give policyholders the right to receive loans up to a specified percentage of cash value (usually somewhere around 80% or 90%).
As long as you have enough cash value built up, the loan will never be denied, and you can use the loan funds for any reason you want (or no particular reason at all).
Importantly, when you receive a policy loan, you’re not actually pulling money out of your policy’s cash value—you’re effectively using cash value as collateral.
With many policies, this means that the entire cash value balance continues growing within the policy, even while a loan balance remains outstanding.
Policy loans provide ready access to cash at low interest rates and with lax repayment terms.
In fact, repayment is effectively optional. You can pay off a policy loan with a lump sum when you have the cash available, pay it back gradually over time, or not pay it back at all—in which case the loan balance is deducted from the policy’s death benefit when triggered.
A policy loan might be used to finance the purchase of another appreciating asset or to invest in a business.
Loan funds can be a source of reserve savings for a financial emergency, avoiding high-interest credit card debt.
Or they can be used to fund your retirement or the education of a loved one.
Only your imagination (but not the insurance company) limits the potential uses.
Retirement Planning
For many policyholders, the need for life insurance wanes as they get closer to retirement age and their children become financially independent.
If you end up in that position, you can use cash value built up in a whole or universal life policy to supplement your retirement budget. And you’ll have a variety of options for doing so.
One approach is to keep life insurance in place but take policy loans as needed during retirement, with the eventual death benefit to repay the loans.
Policy loans are not taxable income, so you won’t incur any income tax liability for the funds during life.
The ultimate payout will be decreased by the loan balance, but the remaining policy value can still serve as a legacy for beneficiaries.
Alternatively, you can surrender a policy for its cash value. When life insurance is surrendered, the insurer cuts you a check for the cash surrender value and is relieved of the future obligation to pay the death benefit.
And, of course, you no longer have to pay premiums.
Funds from a surrendered policy are taxable, but only to the extent the payout exceeds the policy’s tax basis—measured as the total premiums paid into the policy minus any prior dividends or premium withdrawals received by the policyholder.
Stated otherwise, premiums are considered the principal investment into the policy and are non-taxable when withdrawn, but policy growth counts as taxable income when received.
If you make a partial withdrawal from a universal or whole life policy, the IRS assumes the first money to come out is the premium, and, therefore, there is no tax liability until you take out at least as much money as you paid in through premiums.
For some retirees, the smartest play is to convert cash value into a lifetime annuity (a contract under which an insurance company agrees to make regular payments to you for the rest of your life).
Lifetime annuities provide a hedge against “longevity risk,” which is the risk of living long enough to deplete your savings.
So, in a way, when you acquire a lifetime annuity, you’re “betting on yourself” because, the longer you live past your life expectancy, the greater the return will be on the annuity.
If structured properly, the tax code lets you trade life insurance for an annuity without any current tax liability for the policy’s growth.
Current cash value (including growth) becomes the premium payment for the new annuity, and the policy’s tax basis becomes the annuity’s tax basis.
You’ll eventually have to pay income tax on the growth, but an annuity’s extended distribution schedule spreads out the tax liability over the rest of your life (or for a period of years, depending on the annuity you select).
So, you’re avoiding a big tax hit if the growth bumps you into a higher bracket, and the tax-deferred growth previously in the policy continues growing tax-deferred in the annuity until the funds are paid out.
Asset-Based Long-Term Care
Asset-based long-term care (“LTC”) is a fairly recently conceived financial planning strategy that involves leveraging an existing asset (often an annuity or whole life policy) to secure LTC insurance.
Stand-alone LTC coverage (like long-term care itself) is often prohibitively expensive for purchasers at or near retirement age. Many prospective purchasers are put off by the idea of paying very high premiums for coverage they may never need.
However, combining LTC coverage with a whole life policy avoids the risk of “wasting” premium payments because, if you never need LTC, the value within the policy can still be inherited by heirs.
In a nutshell, it works by linking a whole life policy with LTC coverage within a single plan. This can involve either whole life with a rider accelerating death benefits to pay for necessary LTC or a “hybrid” policy that provides separate LTC and death benefits (sometimes with differing coverage amounts) purchased with the same premiums.
In either case, if the insured ends up needing long-term care (such as a nursing home, assisted-living facility, or home-based services), policy proceeds are tapped and applied toward the long-term care expenses—with any remainder paid as a death benefit.
If long-term care is never necessary, the entire death benefit proceeds are paid to beneficiaries.
Whole life policies that provide long-term care benefits often require a significant initial premium investment, especially if the purchaser is near retirement age.
With that in mind, a common approach is to apply the cash value of an existing policy toward the premium for a new policy that has LTC benefits.
When accomplished through a 1035 exchange, there’s no current income tax liability for the prior policy’s growth.
Alternatively, some retirees use IRA or 401k funds to cover premiums—ideally spacing the withdrawals over several tax years to avoid a big income tax hit.
Chronic Illness Rider
Life insurance with chronic illness rider provides access to cash if you are diagnosed with a qualifying chronic illness.
The cash indemnity income benefit is an accelerated benefit derived from your policy’s death benefit.
Depending on the insurance company, you can access virtually all your death benefit in advance if you qualify for the chronic illness rider.
Long Term Care Rider vs Chronic Illness Rider Comparison Table
| Life Insurance with Living Benefit Rider | Long Term Care Rider | Chronic Illness Rider |
|---|---|---|
| What is the Benefit? | Accelerated benefit via advancement from death benefit that may be further supplemented by an extension of benefits rider. | Pays an accelerated benefit which is an advancement of the death benefit |
| Eligibility Requirements | Licensed health professional certifies insured cannot perform 2 of 6 ADLs or severe cognitive impairment, both temporary and permanent | Licensed health professional certifies insured cannot perform 2 of 6 ADLs for last 90 days or severe cognitive impairment with likely no potential for recovery |
| Benefit Payment | Reimbursement or Cash Indemnity | Cash Indemnity |
| Benefit Payment Requirement | May require evidence of actual expenses paid or may be used for any purpose | Generally, can be used for any purpose |
| Is Benefit Payment Taxed?* | Typically not taxable (see IRC Section7702B) | Typically not taxable (see IRC Section 101g), but may be taxed if per diem limit is exceeded |
| Elimination Period | Varies but typically 0, 90, 180 or 365 days | Varies but typically 0-90 days |
| Benefit Amount | 2% to 4% of DB or IRS Per Diem Limits with potential increasing benefits over time due to inflation protection rider, up to full death benefit, with additional extension of benefits possible | Generally based on lesser of 2% to 4% of policy DB or IRS per diem limits |
| Return of Premium | Typically included. 100% ROP after specified period. | Not typically included. |
| Increasing Death Benefit? | Some insurers allow for Option B, increasing death benefit | Some insurers allow for Option B, increasing death benefit |
| Inflation Protection Rider | Included at an additional cost | Not Available |
Guaranteed Death Benefits for Estate Planning
Some folks buy permanent life insurance because they need to know that, no matter how long they live, a guaranteed death benefit will be available when they die. Because by definition term life eventually expires, it can’t provide this guaranty, but whole life can.
There are nearly unlimited reasons why you might want a permanent, guaranteed death benefit.
Life insurance proceeds are tax-free to beneficiaries, so whole life is a tax-efficient way to provide a meaningful legacy for your heirs.
If you hold the insurance in an irrevocable trust or name a testamentary trust as the policy beneficiary, you can provide long-term support and avoid the risk of squandering or attachment by your heirs’ creditors.
Or, you might want permanent life insurance to ensure sufficient estate liquidity to pay final expenses, taxes, outstanding debts, or administration costs.
If, for example, much of the wealth in your estate will be in illiquid assets like real estate or business interests, life insurance proceeds can facilitate easier administration without the need to sell off assets you might prefer to keep in the family.
Conclusion
Cash-value life insurance combines the death benefits normally associated with life insurance with the living benefits of a versatile financial asset.
The life insurance professionals at I&E can help you decide if cash-value life insurance would be a good addition to your financial portfolio.
