Cash value life insurance has been around for hundreds of years, has helped wealthy families pass on their fortunes for generations while avoiding taxes, has saved a myriad of big businesses, and is an asset every bank has on their books.
So why haven’t you heard more about it?
Maybe because you only thought life insurance was for when you die.
What Is Cash Value Life Insurance?
Cash value life insurance is another name for permanent life insurance that pays tax-deferred interest to the policyholder. Universal life, indexed universal life, variable life, and whole life are all types of permanent insurance that can be classified as cash value insurance. Term life insurance, the most common and least expensive type of life insurance, doesn’t earn any cash value.
When you pay an insurance premium on a cash value policy, a portion of the premium goes toward the death benefit (aka the face value). The remainder of the premium goes toward a built-in savings component of your policy (aka the cash value).
So, why not just buy less expensive term life insurance and invest the difference?
- Cash value life insurance comes with a number of living benefits. (Term life insurance offers no living benefits.)
- As an interest-earning asset, cash value life insurance is safer and offers more guarantees than most investment options.
- Cash value life insurance is a phenomenal way to capture opportunity cost.
Benefits of Cash Value Life Insurance
In addition to a death benefit, cash value policies offer living benefits that can be used by the policyholder during their lifetime. These living benefits set cash value life insurance apart from term life insurance and allow it function as a financial foundation made up of these six pillars:
When structured through a mutually funded whole life insurance company, cash value policies offer a guaranteed rate of return. Knowing exactly how much you’ll earn helps take the guesswork out of your financial portfolio.
Cash value insurance offers asset protections and tax advantages that help you keep more of your wealth. Funds in your policy are off-limits in asset searches, judgements, and lawsuits; your policy is a private contract between you and your insurance company.
You can access the cash value of your insurance policy when you need it, regardless of age, without penalties, and for any reason. Compare this to qualified plans or certain money market accounts or CDs, all of which may penalize you for early withdrawals.
Mutually funded whole life insurance companies structure cash value policies that won’t fluctuate when the markets do. Your IRA or real estate investment may take a loss during a market downturn, but the cash value of a whole life insurance policy is protected against market volatility.
5. Cash Flow
Cash value policies are ideally suited to fund or supplement retirement income and can even provide tax-free money in retirement, helping your dollars go further. When you use whole life insurance, you don’t have to worry about market fluctuations wiping out your retirement fund.
Cash value life insurance is ideal for private family banking and can allow you to pass on wealth the same way the Rockefeller family has. When policies are purchased inside an Irrevocable Life Insurance Trust, the cash value of older policies can pay for premiums on newer policies in perpetuity.
How Do I Access My Cash Value?
Once you’ve accumulated cash value, there are a couple of ways you can access it. You can withdraw it or you can take a policy loan.
Making a Withdrawal
The interest (and potential dividends) earned on your cash value insurance policy are tax-deferred, similar to the gains earned on most investments. Any withdrawal you make that exceeds your basis (the amount you’ve paid in premiums) will be taxed. Also, withdrawing cash value reduces the amount left in your policy that can earn interest and reduces your death benefit.
Utilizing a Policy Loan
The most advantageous way to access cash value in your life insurance policy is to take out a policy loan. Policy loans are tax-free; you can borrow your basis (the amount you’ve paid in premiums) plus the amount you’ve earned in interest and dividends without paying any tax. Regardless of your loan amount, you still earn interest on the full cash value of your policy. Essentially, you can borrow a dollar and earn interest on that dollar at the same time.
Your insurance company will charge you interest when you utilize a policy loan. This is typically lower than a bank interest rate. When you consider that you’re still earning interest on the full cash value of your policy, often the effective interest rate of your policy loan is net zero or such that you earn more interest than you pay.
For example, if you have $100,000 in cash value and take out a $20,000 policy loan at a 7% interest rate, the insurance company would charge you $1,400 in loan interest. But if your insurance company is paying you a guaranteed interest rate of 5%, you’re earning $5,000 on your policy. Provided you pay back your loan, you come out on top by $3,600 dollars.
When you utilize a policy loan, you don’t need pre-approval from a bank, you don’t need a good credit score, and you get to decide the payback terms. It’s almost always in your best interest to pay back your loan, but technically you don’t have to. Keep in mind that if your outstanding loan amount, plus interest accrued, exceeds the cash value of your policy, your life insurance could be in danger of lapsing.
What Can I Use My Cash Value for?
Your cash value can be used in a variety of ways, depending on your financial goals. College tuition, business capital, investment opportunities, real estate, family purchases, retirement income and paying policy premiums are some of the most common things policyholders use their cash value to fund.
Increasing college tuition rates and student loan interest rates are making it harder for adults to earn college degrees, but the cash value in an insurance policy can be an ideal way to fund college without strict payback terms and with more favorable interest rates. You can use the cash value of your own policy to pay for your child’s college, or—better yet—get them their own policy.
When you take out a cash value insurance policy on a child, you typically lock in a low premium because children are young and generally very healthy. Use a whole life insurance policy and you’ll lock in that low rate for the remainder of your child’s life. Not only does this put your child at a huge financial advantage in their adult years, it also means they will have accumulated cash value inside their own policy to use toward tuition, or toward their first business, for future investment opportunities, for a downpayment on a house… the list goes on.
For entrepreneurs and business owners, cash value life insurance is an asset that opens many doors. It can be used to generate business capital, cover expenses, create a business succession plan or protect key partners.
Cash value insurance reduces an entrepreneur or business owner’s reliance on banks or hard money lenders by providing a source of funds not dependent upon credit scores or bank approval. By allowing a business owner to function as his/her own banker, the business can capitalize on interest and potential dividends earned, generating more cash flow with less red tape.
Often, investment opportunities arise but a potential investor doesn’t have liquid assets to invest. Cash value life insurance provides liquidity to an investor so they can capitalize on opportunities. And, because every dollar borrowed in the form of a policy loan still earns interest, when you use the cash value of your policy for investment opportunities, you effectively make each dollar work 3 times as hard: It pays for your investment, it earns interest from said investment, and it earns interest inside your life insurance policy.
Cash value life insurance is an ideal source of cash flow for real estate purchases and can be used to cover anything from a downpayment to a property manager to property repairs. Today’s real estate market is seeing historically low interest rates, but depending upon the interest charged by your insurance company and the interest you earn from your insurance company (plus dividends), you might be better off using a policy loan. Plus, mortgage interest rates will eventually go up.
There’s also the matter of liquidity. A policy loan can be deposited in your bank account within just a few days; this may give you the upperhand in being able to make cash offers that would put you at an advantage over other potential buyers.
Cars, boats, vacations… what’s on your family’s bucket list? Cash value life insurance can be a smart way to pay for it. You might be thinking, “Wouldn’t it be smarter to save the money and pay in cash instead of going into debt?” The answer may surprise you.
When you utilize your savings to pay for family purchases (or any purchase, for that matter), you have to factor in opportunity cost. Any interest or dividends you may have been earning on your savings will be wiped out when you withdraw your money. If you utilize a policy loan instead, you still earn interest on the full cash value of your insurance policy. Even factoring in the interest you’re charged by your insurance company, you’ll likely come out on top as long as you pay back your loan.
Using cash value life insurance for retirement, also called a life insurance retirement plan (LIRP), is a good option for individuals who have already maxed out their annual contributions to qualified plans like a 401(k) or IRA but want to contribute more to retirement savings. It’s a good option for individuals who want to retire before age 59 ½ without paying penalties for withdrawing funds from their qualified plan early. It’s also a good option for individuals who prefer not to take on market risk.
Cash value life insurance functions as a volatility buffer in the event of a market downturn either in your retirement years or close to retirement, which can drastically affect your income. In years following a market downturn, utilize policy loans to pay for retirement. Once the market has corrected and your qualified plan has had sufficient time to rebound, you can revert back to relying on funds from your qualified plan.
Using cash value for retirement is likely the only scenario in which you purposely utilize policy loans without the intent to pay them back. Instead, you enjoy the cash value of your policy tax-free to fund your retirement. When you pass away, your outstanding loans and interest are deducted from your death benefit.
Does this mean less for your beneficiaries? Yes. But is the goal in this case to leave a death benefit or to fund retirement?
Paying Policy Premiums
Cash value policies often reach a point where the interest earned on the accumulated cash value is sufficient to cover a policy’s premiums. They are referred to as “self-funding” insurance policies.
When you own a whole life insurance policy, where your premiums are set for life, once your policy is at a “self-funding” stage, you effectively stop paying your premiums out of pocket—the policy itself pays for its premiums. This is an especially effective use of cash value in the later years of your policy, where you are likely retired and no longer have a steady source of income outside funds set aside for retirement.
Is It Worth the Cost?
Cash value life insurance costs more than term life insurance, but the benefits can be far greater. It may not be the right wealth strategy for everyone, but depending on your financial stability and goals, it can be the foundation of a successful financial portfolio, effectively growing and protecting your wealth now and for generations to come.
Determining whether or not cash value life insurance is worth the cost depends on your financial goals and how you intend to use your policy.
If your primary goal is to leave a death benefit for your family in case you unexpectedly pass away, you’re likely better off purchasing term life insurance instead of a cash value policy. It protects your family against the unexpected—provided the unexpected happens during the specified term of the insurance policy.
Should you outlive your term policy, your family will receive no benefit and you’ll likely lose all the money you paid in premiums. You may be able to renew your term policy, but your premium will likely be higher, as it is affected by your health and age.
If your primary goal is to leave a death benefit for your family no matter when you pass away, permanent life insurance can provide that security, as it insures you for the entirety of your life. Your policy will earn cash value, but typically very slowly because the intent of the policy is to create the largest death benefit possible.
If your primary goal is to rapidly earn cash value and utilize the living benefits of whole life insurance for any of the reasons listed in the section above, a cash value policy is ideal and can be structured for rapid growth. When the intent of the policy is to utilize the cash value, the policy is structured with the least amount of death benefit possible and as much going toward cash value as the IRS will allow (without the policy becoming a Modified Endowment Contract and losing its tax-advantaged status).
How your cash value life insurance is structured makes all the difference. If your primary focus is a death benefit, that’s where the majority of your money will go and the cash value aspect of your policy might not seem “worth it.”
But if your primary focus is all of the living benefits of cash value life insurance, you can structure your policy to meet your goals and find great worth in it as a financial tool.
Structuring a Policy for Rapid Growth
Once you’ve determined you want to utilize cash value life insurance for its living benefits, you need to decide how quickly you want your cash value to grow. The best way to amplify the spending power of your policy? Paid-Up Additions.
Paid-Up Additions (PUA) is a type of insurance policy rider—supplemental insurance that allows you to “overfund” your cash value policy so it grows faster. “Overfunding” your policy in its earlier years equates to more cash value over the lifetime of the policy, increased earnings from interest and potential dividends (provided you purchase your policy from a dividend-paying, mutual insurance company), and faster growth.
The PUA rider is only offered on whole life insurance policies—one of many reasons why whole life insurance is ideal for cash value compared to other types of permanent life insurance.
Universal, indexed universal, and variable life insurance don’t offer the option to add on a PUA rider; they also don’t guarantee a set premium for life, a guaranteed rate of return, or offer protection against market volatility. For growth and security, whole life insurance is the most reliable cash value option.
Is Cash Value Life Insurance Right for Me?
If you have a steady source of income and can reliably pay your policy premiums, have long-term financial goals that would benefit from increased cash flow, are in good enough health to qualify for a policy, and are able to take an active role in managing your financial future, cash value life insurance may be the tool you’re looking for. A properly structured cash value policy is crucial to its performance.
At Paradigm Life we can customize a policy to fit your financial situation. Our expert Wealth Strategists are available to answer your questions and show you customized illustrations, outlining an individual plan of action to help you achieve your goals.