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Life Insurance Liquidity & Cash Value

There are several key benefits to owning a permanent life insurance policy, not just for your beneficiaries, but also during your own lifetime. One of these benefits is life insurance liquidity. Life insurance liquidity is the ability to access cash value in your policy whenever you need it. 

Permanent life insurance policies that earn cash value are considered assets because you can essentially cash them in at any time and receive some money in return. You can also utilize policy loans to borrow from your cash value at a favorable interest rate for any reason you need. 

Liquidity is synonymous with flexibility — it’s part of what makes certain types of permanent life insurance so valuable when used as part of a private family banking strategy. In particular, whole life insurance comes with the most guarantees to help you grow and protect your wealth.

Here’s what you need to know about life insurance liquidity before buying a policy.

HOW LIQUID IS LIFE INSURANCE?

Every asset has varying degrees of liquidity. Your biggest asset is likely your home, but it’s hardly liquid—it would require a significant amount of time to turn it into cash and there’s no guarantee how much you’ll get for it. On the other hand, popular stocks can be highly liquid—you can sell off shares in a matter of minutes. 

In order for a life insurance policy to have liquidity, it has to earn cash value. Most types of permanent life insurance meet this requirement, but term life insurance does not. Policies that only offer a death benefit can’t be tapped for cash; it’s exclusively held for your beneficiary, provided you pass away during the specified policy term. 

If the cost of permanent life insurance prohibits you from purchasing a policy right now, but life insurance that earns cash value might be an option in the future, you can purchase a non-liquid term life policy with a term conversion rider that will allow you to upgrade your policy at a later date without an additional medical exam.

Once you’ve purchased (or converted to) permanent life insurance, you begin to earn cash value, thereby increasing your liquidity. The cash value is the amount you can borrow from your policy and is based on the amount you’ve paid in premiums, minus administrative costs and fees, plus any earned interest and dividends. You can also make withdrawals from your cash value, which will decrease the death benefit.

Should you decide to cash in your policy altogether, your insurer will base your payout off your cash value, minus any surrender charges. Surrender charges typically apply if you terminate your policy within the first 10 years and decrease with each year of ownership. 

If you become terminally ill or reach a certain age, you also have the option of selling your insurance policy to a third party. Referred to as a life settlement (formerly called a viatical settlement), a third party buyer may pay you more than your cash value. The going rate is 60% of your death benefit, but outstanding premium payments and accumulated cash value may play a role in your actual payout. Typically, the buyer takes over your policy premiums and receives the death benefit when you pass away, which is a greater value than the cash value of the policy. 

Regardless of how you plan to access the cash value of your insurance policy, it’s important to note that even policies structured for rapid growth can still take several years, or even a decade plus, to accumulate enough cash value for a sizable return. For this reason, life insurance is considered a liquid long-term asset and shouldn’t be relied on for short-term gains.

WHAT ABOUT TAXES?

Because insurance premiums are paid for with after-tax dollars, cash value gains are tax-deferred (similar to a Roth IRA). Cash value is liquid at any time and you won’t be penalized for accessing funds before a certain age, but if you withdraw more than what you’ve paid in premiums, you’ll be taxed on the remainder.

Policy loans are tax-free. You determine the payback schedule, and as long as the policy doesn’t lapse during your lifetime, you won’t owe taxes. Any outstanding policy loans at the time of your death will be deducted from your death benefit plus interest and the remaining death benefit will pass on to your beneficiaries tax-free.

Should you opt to surrender your policy to your insurer, payout amounts above what you’ve paid in premiums will be considered taxable income. Similarly, you may be subject to taxes from gains on a life settlement if you choose to sell your policy. The exception is for terminally ill individuals who typically receive payouts tax-free. 

WHICH TYPE OF PERMANENT LIFE INSURANCE IS BEST?

The right type of life insurance for you and your family depends on your financial goals. If cash value plays a role in helping to accomplish those goals, a permanent life insurance policy can help you get there. But each type of permanent life insurance works a little differently. How your life insurance policy earns cash value depends on the type of policy you buy, and some policies come with more guarantees and liquidity than others:

Whole Life Insurance

Whole life insurance offers the most guarantees and is considered a highly liquid asset. Your insurance company guarantees a rate of return and your payments are guaranteed level for life, making it easy to calculate your profits and expenses. Several whole life insurance policies base your rate of return off your full cash value, regardless of outstanding policy loans, which means you don’t have to sacrifice earnings in exchange for liquidity. Further, policies from mutual insurance companies (also called participating policies) may earn non-guaranteed dividends.

Universal Life Insurance

Universal life insurance earns cash value dependent upon market rates, typically on bonds or indexes like the S&P 500. Level premium payments are not guaranteed, nor is your rate of return, although some insurers will guarantee a low rate of return if market performance is less than projected. On the flip side, insurers often cap gains, so your returns may not be reflective of a particularly successful market year. 

Variable Life Insurance

Variable life insurance works similarly to universal life insurance in that your cash value is dependent upon the market, although it’s more common to invest cash value in mutual funds than indexes here. Most variable policies have level premiums, which provide some certainty, but gains fluctuate and administrative costs tend to be high. 

IS A LIQUID LIFE INSURANCE POLICY RIGHT FOR ME?

Having cash on hand is invaluable in today’s society. Have you ever had an investment opportunity come your way but didn’t have the liquidity to act on it? Or had to deal with an unfavorable bank loan? Or been faced with a financial emergency and had to rely on credit cards? Or made an offer on a large purchase only to see it go to a buyer who offered cash instead?

Owning a permanent life insurance policy can serve multiple functions over your lifetime:

  • When you have young children, it provides peace of mind that your family will be taken care of if something happens to you. 
  • It can act as your emergency fund.
  • It can help you consolidate high-interest debt.
  • It can be used to finance cars, real estate or other major purchases.
  • It can be used to capitalize on investment opportunities.
  • It provides an alternative investment option if you’ve maxed out qualified plans like a 401(k) or prefer to diversify your financial portfolio away from the market.
  • If you open your own business, it can act as a source of business capital and provide a business succession plan in your absence.
  • When your children go to college, it can be used to pay for tuition.
  • It can act as income replacement if you decide to make a career change or need to stop working to care for a loved one. 
  • It can be tapped for early retirement income without the penalty associated with withdrawing from a qualified retirement plan before age 59 ½. 
  • In retirement, it can be used as an additional source of income, particularly during a market downturn where your 401(k) takes a hit.
  • It offers tax advantages and can be used to lower or eliminate estate taxes.
  • It can be used to create generational wealth.

Given the versatility of permanent life insurance, it should be considered a valuable asset that accomplishes a wide array of financial goals. As your financial situation changes over your lifetime and priorities shift, the right kind of life insurance can evolve with you.

If even one of the functions of permanent life insurance listed above peaks your interest, it’s worth investing an hour of your time into a free consultation with a Paradigm Life Wealth Strategist to learn more about how cash value in life insurance can help you achieve your specific financial goals. 

With a significantly better rate of return than a bank savings account and significantly less risk than market based investments, the right permanent life insurance policy is proven to help grow and protect wealth and is one of the most valuable assets you can have in your financial portfolio.