As part of our series on what you can do if you cannot pay your whole life insurance premiums, we offer this article on reduced paid up insurance.
Whole life insurance comes with two principle features that set it apart from term coverage.
The first feature is that a whole life policy is guaranteed to stay in place for your “whole life,” with a guaranteed fixed premium level. That means, as long as you continue paying the premiums, the whole life policy will never expire – regardless of how long you live.
In contrast, term policies eventually reach the end of the term, and the coverage lapses. With whole life, though, the policy is guaranteed to pay out a death benefit.
The second defining feature of whole life is that it accrues cash value. The longer a policy is in place, the greater the cash value becomes, eventually surpassing the initial face value (the death benefit amount) of the policy.
The simplest way to think of your policy’s surrender cash value is that it is the amount the insurance company would pay you if you chose to close (i.e. surrender) the policy.
“Surrendering” a whole life insurance policy basically means electing to forego the death benefit and instead receive the cash value in the form of a lump-sum check or annuitized payments from the insurance company.
For this reason, a policy’s cash value is also sometimes referred to as its “surrender value.”
Surrendering a whole life policy for cash makes sense in some situations, but cashing out is by no means the only option for taking advantage of cash value.
This is because cash value is not just a theoretical sum the insurer is willing to pay now to avoid a future obligation to pay the death benefit.
It is an actual financial asset – a separate account that grows with each premium payment and earns interest.
After a whole life policy has been in place long enough, the policy’s cash value can serve as collateral for a low-interest loan from the insurance company.
Cash-value loans, which are usually not included in credit reports, come with attractive terms because they are low-risk to the insurance company – if you don’t repay the loan before dying, the outstanding amount is simply deducted from the policy’s death benefit.
No More Premiums
Another underrated option for capitalizing on accrued cash value is to use it to secure life insurance coverage that doesn’t require any further premiums.
One approach is to surrender a whole life policy and apply the cash value as a lump-sum, upfront premium payment for an extended term policy that doesn’t require any further premiums for the duration of the policy.
Depending on your age, health, and total premiums paid, this can end up being a good deal, but, of course, you no longer have permanent life insurance. So, if you outlive the term, you won’t receive any pay-out.
Reduced Paid-Up Non-Forfeiture
But, if you want to retain permanent life insurance, and still avoid further premiums, there’s a way to do that, too.
Almost every whole life policy includes a “reduced paid-up (RPU) non-forfeiture option.”
If elected, the option allows you to apply accrued cash value as a lump-sum premium payment toward a pre-paid whole life policy with a lower death benefit than the current policy.
What you are essentially doing is decreasing a policy’s death benefit to a level where, based on the premium payments to date, the policy would have been paid-up, creating a reduced paid-up whole life insurance policy.
Breaking Down the Reduced Paid-Up Non-Forfeiture Option.
To get a better understanding of RPU, let’s break down the concept to its component parts.
- “Reduced” – When you exercise an RPU option, you are reducing the policy’s death benefit in exchange for removing any obligation to pay further premiums;
- “Paid-Up” – The policy is now effectively paid-in-full; the cash value that is traded in constitutes a single, lump-sum premium payment sufficient to keep the policy in place for the rest of your life;
- “Non-Forfeiture” – The policy cannot be forfeited or lapse in the future because all premiums have been paid in advance;
- “Option” – RPU is an option because it’s something you can but are not required to do; there are certain eligibility criteria, but once you meet them, you have a contractual right to elect the (RPU) option.
Electing a Reduced Paid-Up Non-Forfeiture Option.
The precise eligibility criteria and requirements to activate an RPU option vary between policies and insurance companies.
With any whole life policy, before the option can be elected, the policy must have been in place for a minimum period and/or have received a minimum aggregate sum of premiums.
Three years is typical, but some policies require longer, and if you have made additional premium payments, a policy might allow you to make the election earlier.
Cash VALUE = Death Benefit
When you opt for RPU, the new death benefit will be at least equal to the current cash value.
The insurance company uses multiple factors to make the precise calculation, including how long the policy has been in place, the total premiums paid, the current cash value, and your age.
Generally, a policy that has been in place longer will have accrued a higher cash value and therefore receive a higher death benefit.
Likewise, any prior premium over-payments raise the cash value, leading to a higher adjusted death benefit.
All things being equal, a younger policyholder will receive a higher death benefit because the insurer anticipates having more time to invest the premium before paying out the death benefit.
Importantly, after an reduced paid-up option is exercised, the policy still has a cash value. So, you can still take loans against the policy or surrender it for cash or an annuity – should you so choose.
And, the policy is still a whole life policy, so it will continue to earn interest and may receive life insurance dividends even though no further premium payments are made.
Who Might Benefit from Electing an RPU Option?
An RPU option can be beneficial for individuals who want or need some life insurance but whose situation has changed – such as recent retirees – so that it no longer makes sense to pay premiums and maintain the current level of coverage.
Or someone who wants to retain a death benefit but can no longer afford monthly premiums can prevent a policy from lapsing by exercising an RPU option.
From a tax-savings standpoint, an RPU election can be advantageous for an insured looking to avoid the income tax hit involved in cashing out a policy that has substantially appreciated.
Because a life insurance pay-out is not taxable income and policy proceeds can relatively easily be kept out of a taxable estate, an RPU election minimizes tax consequences while still avoiding further premiums or a policy lapse.
As an example, let’s say you have a policy with a $100,000 death benefit, an accrued cash value of $35,000, and you have thus far paid aggregate premiums of $25,000. You’re getting ready to retire, the kids are self-sufficient, and you no longer need $100,000 in life insurance coverage.
If you surrender the policy, the $10,000 in growth will be taxable income.
But, if you elect reduced paid-up life insurance, the policy will convert to a death benefit of at least $35,000, payable upon your death to your named beneficiary tax-free.
Moving forward, the policy will continue to grow thanks in part to guaranteed interest and potential dividend payments, but you’ll never have to make another premium payment.
And, if you ever need ready liquidity, you can always take out a loan or surrender the policy for the cash value.
Downsides of an RPU Election.
The obvious drawback to an RPU election is that the policy’s death benefit is reduced.
So, if you’re still relying on the full amount of the benefit to provide for your loved ones, fund a trust, or pay estate expenses, you probably shouldn’t make an RPU election.
But if you have reached a point where you don’t need as much or any life insurance, RPU can make sense.
If your other assets will be sufficient to take care of any dependents, electing RPU to halt premium payments and free up funds in your budget can be a good financial move.
Another consideration is that coverage provided after an RPU election is usually more stripped down than prior to the election, in life insurance riders may not survive the transition.
So, if you’re counting on a rider that triggers coverage in the event of a terminal illness or severe injury, for example, an RPU election might not be a good idea.
Finally, for the most part, reduced paid-up insurance elections are irrevocable. Some states and policies allow for reinstatement within a certain amount of time, usually requiring the policyholder to catch up on premiums.
But, in most cases, once a policy is converted to RPU, there’s no going back. That usually means that, not only are you relieved of the obligation to pay future premiums, but you cannot choose to pay additional premiums either.
So, you won’t be able to use the whole life policy’s guaranteed growth as a hedge against poor performance by other investments.
Similar Life Insurance Concepts.
Premium offset is a whole life strategy under which a policyholder applies the policy’s dividends, growth, and any previous additional premium payments toward future premiums.
Premium offset maintains the policy’s death benefit but limits future growth because some or all of the growth is applied toward underwriting costs (i.e., premiums) rather than cash value.
Unless the policyholder has made substantial premium over-payments, a policy will have to have been in place for many years before dividends and growth are sufficient to sustain it.
By contrast, RPU can usually be elected earlier, but, of course, requires a death-benefit reduction. Premium offset also differs from RPU in that the former can be elected temporarily.
So, for example, a policyholder can choose to offset premiums with dividends and growth for a year or two and then resume payments if warranted by market conditions or personal financial circumstances.
Paid-up additions are often described as miniature life insurance policies that act as a supplement to a primary whole life policy.
The mini-policies are purchased in full using dividends and require no additional premiums (hence ‘paid-up addition’). Once a paid-up addition is purchased, its death benefit is guaranteed for life.
The right to purchase paid-up additions is offered through policy riders that usually require a higher starting premium.
In many cases, paid-up additions can still be purchased after an RPU election – provided the rider was included with the original policy and survives the election.
As a result of the decreased death benefit following an RPU election, the dividend amount (and therefore the paid-up addition’s death benefit) usually decreases, at least for a while.
The reduced paid-up nonforfeiture option is one of several ways in which whole life policyholders can adapt policies to ever-changing life circumstances, financial situations, and market conditions.
Though the option is required in many states, the precise terms and requirements vary among insurance companies and between policies.
Before making an RPU election, policyholders should discuss the implications with an experienced life insurance adviser and carefully consider the pros and cons of exercising the option.