A whole life insurance policy is “paid-up” when no further premium payments are needed to keep the policy in force. Paid-up life insurance allows you to benefit from the continued growth of the policy, without needing to pay into the policy to keep it active. And for properly designed policies, the cash value and death benefit will continue to grow.
There are several scenarios (discussed below) that can result in a paid-up life insurance policy, but what it boils down to is that the insurance company has already received all required insurance premium payments for the policy to stay in force, so the policyholder gets to enjoy the benefits of life insurance coverage without making any more payments.
Although other insurance products can be set up to stay effective without additional premiums, the term “paid-up” is usually applied to permanent life insurance, particularly dividend-paying whole life insurance.
The main ingredient that allows life insurance to be paid-up is the cash value. Term insurance has no cash value, so it cannot be paid-up. However, return of premium life insurance has some cash value and can be converted to a paid-up life insurance policy.
In general, whole life insurance policies require consistent, fixed premium payments for as long as the policy remains effective. In return, the policyholder receives a death benefit guaranteed for life without any increases to premiums, along with a steadily growing cash value which can be withdrawn, borrowed against, or cashed out for the policy’s surrender value.
One of the many advantages of cash value whole life insurance is that, when the cash value accumulates to a high enough level, the policy can be converted to paid-up status, meaning no further premiums are owed.
Paid-Up Life Insurance Policy Cash Value
The way it works is that, after you keep a whole life policy in place long enough, its cash value reaches the point where it can cover the premiums. When that point is reached, you can elect to have the insurance company treat the policy as paid-up. Each month thereafter, the company pays the premiums from the cash value. The policy stays in force, but you no longer have to make payments because premiums are being paid from the policy’s own cash value.
The drawback of using cash value to convert your whole life insurance policy to paid-up status is that each premium payment reduces the cash value and eventually the death benefit paid to your beneficiary. The decrease is more or less like you made a withdrawal from the cash value and used the money to pay the premium yourself.
Importantly, though, the savings component of the policy earns guaranteed returns, resulting in a cash value greater than just the aggregate percentage of premiums applied to savings.
With a policy in paid-up status, this growth helps offset reductions to the death benefit. Depending upon the total returns earned thus far and how long the policy stays in paid-up status, the decrease in the death benefit can be negligible or it can end up being significant.
Converting a whole life policy to reduced paid-up status amounts to a compromise between surrendering the policy outright for cash and continuing to pay premiums on life insurance that might no longer be a necessity.
It can be a good strategy to use paid-up life insurance if you want to keep retirement expenses down while still ensuring a death benefit for your heirs and liquidity in your estate. When the death benefit is eventually triggered, the pay-out will be the policy’s face value minus any reductions resulting from the application of cash value to premium payments.
Importantly, a policy can only be converted to paid-up status if allowed by the policy terms, and only if sufficient cash value has accrued to cover the premiums. If you’re interested in electing reduced paid-up status for your existing whole life policy, you should review your policy and talk with your life insurance agent or insurance company representative about whether your policy is eligible and, if so, what you need to do to make the election.
While some whole life insurance policies include provisions designed to prevent inadvertent cancellation by automatically converting to reduced paid-up status if premiums are missed, some companies require specific action by the insured. You should not assume that simply discontinuing premium payments will convert your policy to reduced paid-up status – no matter how long it has been in place.
Limited Pay Life Insurance
Policies with a predetermined, agreed paid-up age or time length are an interesting variation on paid-up whole life insurance. These limited pay life insurance policies become paid-up when the insured reaches a number of years or certain age, such as to age 65.
The idea is that, in exchange for making higher premium payments during your working years (thereby building up cash value faster), you eliminate premium payments during retirement without drawing down the death benefit your heirs will receive.
The cash value is still available as an emergency fund or for loans, but if you decide to make a withdrawal for the surrender value of the policy, premium payments might being again. Alternatively, the death benefit could be reduced if you fail to repay a loan against the policy.
A limited pay whole life insurance policy is a good alternative if you can afford higher premiums during your working years, will have a tighter budget upon retirement, and need to make sure the death benefit stays effective in the full amount.
For instance, if you need to be certain your estate includes sufficient liquid assets to fund a trust for the support of a dependent and are unsure how insurance premiums will fit into your retirement budget, you might want to consider a whole life policy with a predetermined paid-up age or number of years.
Caution needs to be taken when designing a policy intended for paid-up life insurance. There are rules in place as to how many payments must be made. If you do not adhere to the rules set in place by the Internal Revenue Code you run the risk of creating a Modified Endowment Contract, rather than cash value life insurance.
Cash value life insurance requires in part that the policy meet the guidelines of section 7702 of the Internal Revenue Code. Basically, the policy must adhere to the 7-pay test criteria as outlined in the code.(1)
Sometimes it makes sense to choose single-premium life insurance, particularly when you want long-term care insurance. Certain hybrid life insurance long-term care insurance policies can be designed as single premium policies, allowing you to make a lump sum payment in return for a long-term care benefit available throughout your lifetime, that pays a death benefit if the long-term care benefit is not utilized.
Also, second to die life insurance as a single premium paid-up life insurance policy is beneficial for estate planning purposes, where the primary use of the coverage is for liquidity for the estate and to pay potential estate taxes.
What are Paid-Up Additions?
Paid-up additions are supplemental life insurance purchased using dividends earned on an existing whole life policy. The purchase of additional life insurance using dividend payments does not require evidence of insurability.
Life insurance dividends are annual payments issued by mutual insurance companies to policyholders based upon the company’s performance. Though they are technically not guaranteed, some companies have paid dividends so consistently over the years that they are all but certain.
For tax purposes, whole life insurance dividend payments are treated as if the insurance company refunded a portion of the premiums you already paid, so dividends are not taxable income.
When you, as a policyholder, receive a dividend, you have a wide range of options for using the funds, including just asking the company to cut you a check.
Perhaps the most attractive of these options, though, is to use your dividend to purchase additional paid-up life insurance. When you purchase a paid-up addition, your policy’s cash value and death benefit both increase based upon the amount of the dividend applied. And the additional coverage is paid-up – you never have to make any more premium payments for it.
Think of paid-up additions like smaller, pre-paid policies attached to your whole life policy. Regular premiums are still due for the underlying policy, but the additional coverage is yours as soon as the dividend is applied – nothing further owed.
The icing on the cake is that the cash value of the paid-up addition earns interest and more dividends, both of which are tax-deferred, providing a true compound interest account.
And, like the primary policy itself, paid-up additions can be surrendered for their cash value or borrowed against.
Paid-up additions are a great way to increase your coverage without applying for a new policy, an especially attractive feature for older policyholders. Notably, though, not all whole-life policies pay dividends convertible to paid-up additions.
A dividend-paying policy is referred to as a “participating policy,” while a policy not eligible for dividends is “non-participating.” All things being equal, non-participating policies usually have lower premiums or a higher initial death benefit, but the value provided by dividends almost always more than makes up for the difference before long.
Paid-Up Additions Rider
Along with allowing purchases of paid-up additions using dividends, some whole life policies include riders permitting the purchase of paid-up additions through voluntary supplemental premium payments. Any paid-up additions purchased in this manner are treated similarly to additions acquired using dividends (i.e., cash value and death benefit increase with no further premiums owed).
Paid-up additions, whether purchased with dividends or with cash, can complement a “paid-up” retirement strategy in which premiums are paid with cash value. Beyond just increasing the policy funds available for the premium payments, the extra coverage provided by paid-up additions helps offset death benefit reductions resulting from application of cash value to premiums.
Moreover, paid-up policies usually continue to receive dividends, so you can still buy paid-up coverage with dividends while at the same time applying cash value toward premiums.
At Insurance&Estates, we specialize in designing these types of policies that utilize paid-up additions, so the policy’s focus is on early high cash value growth. These policies are excellent savings vehicles, which act as an alternative to traditional banking. Rather than putting your money into a bank account where you get at most 1% interest, you can earn 4-5% interest outside of the purview of big banks.
If you are interested in learning more please check out our resources page. In addition, you can always give us a call for a complimentary strategy session.