While many people purchase life insurance for the income tax free death benefit that it can provide to their survivors, there are numerous other ways that this flexible financial vehicle may be used in a financial or retirement plan – even when the insured is alive.
One of these is the ability to access funds tax-free from a permanent life insurance policy’s cash value. This money can then be used for any need or want, such as supplementing retirement income, making purchases, and/or paying off high-interest debt.
Not all life insurance policies are exactly alike, though, so it is important to understand which type of life insurance policy generates immediate cash value if you plan to take advantage of these funds.
In addition, there are also certain rules that can come into play when structuring a cash-rich life insurance policy. If these guidelines are not followed, you could lose the tax-free nature of the money that you access.
So, walking through the process of setting up a plan with a life insurance specialist can help you to narrow down the right policy and strategy, based on your particular needs, time frame, and objectives.
How Life Insurance Cash Value Works
Although there are many different types of life insurance policies in the marketplace today, there are two primary categories. These are term and permanent. Term life insurance provides death benefit coverage for a pre-set period of time (provided that the premium is paid), such as 10 years, 20 years, or even 30 years.
Term is the most basic form of life insurance, as there is no cash value or investment component associated with the policy. After the time period, or “term” of coverage has elapsed, the policy will typically expire.
One enticing feature that is associated with term life insurance is that the premium is usually low – especially if the insured is young and healthy at the time they apply for the coverage. However, if the convertible term life insurance coverage is renewed in the future, the premium will be based on the insured’s then-current age and health condition.
Therefore, the premium cost of term life insurance could escalate significantly – and in some cases, if the insured has contracted an adverse health condition, they may not be able to renew the coverage at all.
Conversely, permanent life insurance offers a death benefit and a cash value component. In most cases, as long as the premium is paid, permanent life insurance will remain in-force – even as the insured ages – and regardless of whether they incur any serious health issues.
The funds that are in the cash value component of a permanent life insurance policy are allowed to grow on a tax deferred basis. This means that there is no tax on the growth unless or until it is withdrawn.
Fully Taxable vs. Tax Deferred Growth
(with all other factors being equal)
Tax deferral can help to increase the cash value in a policy more quickly because a return is being generated on the:
- Premium(s)
- Previous gains, and
- Funds that would have otherwise been paid in taxes
How much growth is attained – and how long it can take funds from the cash value to increase – can depend on several factors. One of the biggest of these is how and when the policy’s premium(s) is paid in, and how the return in the account is generated.
Life Insurance with Immediate Cash Value
While all permanent life insurance policies can build cash or investment value, some can take longer than others to build up. One reason for this is because different types of policies have differing criteria for how the return in the account is calculated. (And in some cases, like variable life insurance, there is the possibility of loss in the account if the underlying investments perform poorly).
Two types of cash value-generating life insurance that are oftentimes used include whole life and universal life insurance. With a whole life insurance policy, the premium and the death benefit will remain constant going forward, whereas with universal life insurance, you have more flexibility over the premiums over time.
Based on the specific permanent life insurance policy, the premiums could be due monthly, semi-annually, or annually. Others may be “paid up” after you pay in a certain number of larger premiums, such as a 7-pay or 10-pay policy. Further, there are also permanent life insurance policies that allow you to make just one large single premium payment.
Whole life insurance typically has immediate cash value. It can also have more flexible options and features for cash value accumulation as compared to universal life, indexed universal life, and variable universal life insurance policies.
Single premium whole life insurance is considered to be fully funded right away (i.e., as soon as the premium is paid). Therefore, the cash value in these plans can build up quickly. (In this case, the amount of the death benefit can vary, based on how much premium is contributed, as well as the age and health of the insured at the time of policy application).
There are different ways that you could fund a single premium whole life insurance policy. These methods could include:
- Using funds from a personal savings or checking account
- “Exchanging” funds from another similar policy (a process known as a 1035 exchange whereby cash value can be moved to a different policy tax-free)
As with other types of permanent life insurance policies, you can access funds from a single premium plan either through withdrawals or loans. Some single premium life insurance policies may also allow you to finance long-term care services using these funds. While doing so can reduce the amount of the death benefit on the policy, it could also allow you to keep your retirement savings in place to be used for their originally-intended purpose.
How Soon Can You Borrow from Your Life Insurance Policy?
There are a couple of ways that you may access funds from a permanent life insurance policy’s cash value. These include:
- Withdrawals
- Loans
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 2022
| Tax Rate % | Single | Married Filing Jointly |
|---|---|---|
| 10% | Up to $10,275 | Up to $20,550 |
| 12% | $10,276 to $41,775 | $20,551 to $83,550 |
| 22% | $41,776 to $89,075 | $83,551 to $178,150 |
| 24% | $89,076 to $170,050 | $178,151 to $340,100 |
| 32% | $170,051 to $215,950 | $340,101 to $431,900 |
| 35% | $215,951 to $539,900 | $431,901 to $647,850 |
| 37% | Over $539,900 | Over $647,850 |
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.
If you plan to borrow money from your life insurance policy, you can generally do so as soon as there is enough money built up to take a loan in the amount that you need. Policy loans can be taken tax-free, so there are no surrender/early withdrawal charges. Nor will you have to pay tax on the funds that you borrow – as long as they are repaid either during the insured’s lifetime, or afterwards through the death benefit proceeds.
A permanent life insurance policy with cash value that is available immediately can give you more choices and control over what to do with your money. It can also provide you with some enticing tax-related benefits on the funds that you access through loans, as well as on the growth of the money that is still inside the account.
How Much Does Whole Life Insurance Cost?
There are several factors that can determine the cost of a life insurance policy. These include the:
- Age, gender, and health condition of the insured
- Whether or not the insured is a smoker
- Amount of death benefit coverage being purchased
- Type of coverage (i.e., death benefit only term life insurance or a death benefit with cash value with a permanent policy)
Keep in mind that, even though permanent policies like whole life insurance can start out being “more expensive” than term life insurance (with a comparable amount of death benefit), there is no “expiration date” for whole life coverage.
But do whole life premiums increase with age?
The good news is that they do not!
In addition to cash value build-up and tax-free death benefits, another nice feature that is associated with whole life insurance is that the premiums do not increase as the insured gets older. Therefore, if a policy is purchased when the insured is young and healthy, a low-cost premium can be locked in for the remainder of his or her lifetime – regardless of how long that may be.
How to Borrow Money Tax Free from Whole Life Insurance
Although most people do not like to borrow money and increase the amount of their debt, taking loans from whole life insurance can actually have a number of advantages – starting with the fact that the money is received tax-free.
This means that you can count on a certain amount of money to spend, regardless of what the income tax and capital gains tax rates are at that time. In addition, unlike getting a loan from a bank or other traditional lender, borrowing from a life insurance policy will not impact your credit score.
Similarly, there is no approval process to go through in order to qualify for a life insurance policy loan. In many cases, you can have the money in hand within just days (or less).
It is important to note that the life insurance company will typically charge interest on a policy loan. Although, the interest rate is usually lower than a bank loan or credit card. In addition, there is no mandatory monthly payment for repaying these borrowed funds. (Although a balance will accrue).
If the insured passes away while there is still a remaining balance (plus accrued interest) on the policy loan, the remainder will be repaid using proceeds from the death benefit. Then, the remaining amount will be distributed to the policy’s beneficiary(ies).
There is also an additional “bonus” that is associated with borrowing from a properly structured whole life insurance policy, and that is the return on the cash value continues to be generated as if no money was taken from the account…because, technically, it hasn’t.
For example, if your whole life policy’s cash value is $80,000 and you borrow $40,000, interest will continue to accrue on the full $80,000. This is because you are actually borrowing money from the insurance company and only using the cash value as collateral.
Some life insurance companies also pay dividends to their policyholders. Life Insurance Dividends are considered to be a return of excess premiums. Even though dividends are not guaranteed, there are some insurers that have consistently made dividend payments for more than 100 years. In some cases, dividends might even be enough to cover the interest on the policy loan, in turn, making the borrowed money “free” to you.
What to Look for When Choosing a Life Insurance Policy
Purchasing a whole life insurance policy can be a long-term financial commitment. So, it is essential that you consider several important criteria when doing so. These should include knowing about the following:
1. The amount you can borrow from the particular policy.
All insurance companies (and policies) can have different rules regarding how much you can borrow. Typically, though, the most you can borrow is up to 90% of the cash value.
2. How soon you can start borrowing.
You can generally borrow from your life insurance policy as soon as there is enough cash value built up for what you need. If you pay your policy’s premiums monthly or annually, though, it can take longer for the cash to accumulate as compared to a single premium life insurance policy.
Different companies have different timelines on how soon you can take out a loan against your cash value. There are companies that like you to wait 30 days, while other companies have a 90 day period they prefer you wait before taking out a loan.
3. The amount of the premium.
Just like making any other “high ticket” purchase, before you commit to buying a life insurance policy, you should make sure that you compare several plans. This is because the amount of the premium can differ from one to another – even with the same amount of coverage, features, and benefits. In this case, it can help if you work with an independent life insurance specialist who can run several policy comparisons for you.
4. Whether the policy is participating or non-participating.
Participating whole life insurance policies pay dividends (if applicable), which could help you to increase the return on the cash value. Non-participating policies do not pay dividends to policyholders.
5. Financial Strength of the Company
The financial strength and stability of the life insurance company matters, so it is recommended that you check out the financial strength and stability of the insurance carrier, as well as its reputation for paying its claims. Y
ou can do this by reviewing the ratings that the insurer has been given by Standard & Poor’s, A.M. Best, Moody’s, and/or Fitch Ratings. You will typically want to stick with insurance carriers with ratings of A or better. A life insurance specialist can also assist you with finding this information.
Finding and Customizing the Right Life Insurance Policy for Your Specific Needs
A properly structured permanent life insurance policy with cash value could be an integral component of your overall financial and retirement plan. There are many different policy options, though, so it is critical that you go with the one that best fits your particular needs, goals, risk tolerance, and time frame.
Getting advice from an expert can help you to better understand why specific options may (or may not) be right for you. In addition, an experienced life insurance specialist can also generate policy illustrations that show projections of how much cash value could grow to over a certain period of time.
At Insurance and Estates, our mission is to ensure that consumers truly understand how certain financial vehicles can impact their short- and long-term financial goals. If you would like to obtain more information on generating income tax-free funds – while at the same time protecting your loved ones in case of the unexpected – contact us at (877) 787-7558 or send us an email with any questions that you may have by going to info@insuranceandestates.com. We look forward to helping you build financial security for now and the future.
