Variable life insurance is one of several types of permanent life insurance that come with a built-in savings component called cash value. On paper, it offers policyholders the best of both worlds: life insurance with a death benefit payout for beneficiaries and money that can be invested similar to a mutual fund or other market-based investment. But is this 2-in-1 insurance product the best way to utilize cash value, and is it right for you?
What Is Cash Value?
Certain types of permanent life insurance, variable life insurance included, divide premium payments into two accounts: some of the premium goes toward purchasing a death benefit (and the fees associated with it), the rest is put into a part of the policy called cash value.
In many cases, cash value earns interest and even potential dividends. It can be used to grow tax-advantaged wealth and functions as a living benefit for the policyholder.
Policyholders can use the cash value of life insurance in a variety of ways, depending on the type of insurance policy. Cash value can be used to pay premiums, it can be borrowed in the form of tax-free policy loans, it can be withdrawn by the policyholder, and it can even be used to fund retirement. If you were to surrender your life insurance policy, the cash value represents the amount your policy is worth.
How Variable Life Insurance Works
In the case of variable life insurance, cash value inside the policy can be invested in SEC-regulated sub-accounts that function like mutual funds. These sub-accounts may be equities, indexes (like the S&P 500), bonds, or money market accounts; your options depend on your insurer and associated brokerage.
When sub-accounts perform well, earnings can be used to increase the death benefit of the policy, essentially purchasing more life insurance. Cash value in a variable life insurance policy can also be borrowed as a policy loan or withdrawn.
How It Works: Premiums & Fees
One of the appealing features of variable life insurance is flexible premium payments. Many policies allow you to use your cash value to pay premiums and let you overpay for faster cash value growth, up to a certain limit. You can also find single premium policies that let you fund the policy with one large, lump-sum payment.
Like other types of cash value life insurance, variable life insurance premiums are divided up between policy payments to your insurance company and the cash value of your account, but there are additional fees to consider.
Of all types of permanent life insurance, variable life insurance tends to have the highest fees. Not only do you pay administrative fees for your policy (these are charged with all types of insurance policies), you’re also subject to management fees when you choose to invest your cash value. These fees vary and increase depending upon how actively your investments are being managed.
Management fees are often referred to as basis points, with 1 basis point equal to 0.01%. If your investment earns 8% and is charged 200 basis points in management fees, 2% of your return is going toward fees, for a net earnings of 6%.
Often, insurance companies put a cap on how much you can earn with a variable life insurance policy and don’t offer a guaranteed rate of return. In a market downturn, your investments may underperform with no guaranteed earnings. During growth years, your investment gains may be limited to what your insurer allows.
How It Works: Death Benefit
Variable life insurance death benefits can be structured in three ways:
- Level Death Benefit
- Face Amount + Cash Value
- Face Amount + Premiums Paid
A level death benefit functions like a typical life insurance death benefit; the face value of the policy is paid out to your beneficiary when you pass away. With variable life insurance you also have the option of giving your beneficiary your cash value or a return of all the premiums you paid. Face amount + cash value and face amount + premiums paid options will increase your insurance premiums during your lifetime but may provide your family with a greater payout after you’re gone.
It’s important to work with a Wealth Strategist or insurance broker to understand exactly how your individual policy is structured. Some variable life insurance policies don’t guarantee death benefits and pay out less if your invested cash value underperforms, which could leave your loved ones with insufficient income after you pass away.
How It Works: Tax Benefits
Variable life insurance receives preferential tax treatment by the IRS similar to other types of permanent life insurance. Cash value in your policy grows tax-deferred. The death benefit is usually tax-free for your beneficiary. You can utilize tax-free policy loans. You can take tax-free withdrawals up to the point of your basis (the amount you’ve paid in premiums). Your variable life insurance policy can also be used to help fund a tax-free retirement.
Investment earnings from the policy’s cash value are subject to income taxes, like other types of market investments, if they are withdrawn or if a policy lapses with unpaid policy loans during the policyholders lifetime.
Due to additional state tax laws and other legal implications, it’s important to work with a qualified tax professional if you’re considering variable life insurance so you can optimize the tax advantages of your policy.
How It Works: Policy Loans
Policy loans with variable life insurance work the same as policy loans with other types of cash value insurance. Policyholders can borrow cash value for any reason, usually at any time. Your insurance company will charge interest on your loan (typically less interest than a bank or other lender) but you determine the payback schedule.
Policy loans are tax-free, even over your basis (the amount you’ve paid in premiums). If you pass away with outstanding loans, the unpaid loan amount will be deducted from your death benefit. If your policy lapses, you may owe taxes on outstanding loan amounts.
How It Works: Policy Riders
Policy riders are supplemental insurance that can help you customize your variable life insurance policy to better fit your individual needs. Riders may increase your policy premiums. Common riders purchased with variable life insurance include:
- Disability rider: suspends premium payments if you become completely disabled.
- Accelerated death benefit rider: pays out a portion of your death benefit while you’re living if you become terminally or chronically ill.
- Long-term care rider: provides additional income while you’re living if you need long-term care not covered by medical insurance.
- Term life insurance rider: provides additional coverage for a predetermined term to help cover debts or other insurance needs.
How It Works: Cancellation
Most insurance companies offer a free-look period where a policyholder may cancel a policy without any financial implications to the insurer (although there may be fees associated with brokerage or administrative costs). If you decide to terminate your policy after the free-look period has passed, you may be subject to a surrendered charge, depending on how long the policy has been in force.
If you rely on cash value to fund a portion or all of your premiums in a variable life policy, your cash value may become insufficient, especially if investment performance is poor. This may cause your policy to lapse. You will lose insurance coverage and your beneficiaries will not receive a death benefit.
Is Variable Life Insurance Worth It?
For individuals who have already maxed out other investment options and who desire additional life insurance, variable life policies may be an interesting option. It offers tax advantages, especially for high net worth individuals and can function as a long-term savings and investment vehicle.
But of all the types of life insurance, it tends to be the most expensive due to management fees. With caps on gains and no guaranteed rate of return, investors looking to maximize cash value may have better options than variable life insurance, and for those who just need basic coverage to protect loved ones, this type of policy poses a great amount of risk.
Variable Life Insurance Alternatives
Whole Life Insurance
Whole life policies offer a guaranteed death benefit, level premiums, and a guaranteed rate of return and may offer dividends when underwritten by mutual insurance companies. Fees are significantly lower because there are no management fees for your cash value.
Whole life insurance doesn’t offer sub-accounts to invest in, but policyholders may utilize policy loans and invest funds privately. Additionally, policies continue to earn interest on the full cash value regardless of how much is being borrowed in a policy loan—you can borrow a dollar and earn guaranteed interest on it at the same time.
Universal Life Insurance
Universal life policies offer flexible premiums and fluctuating rates of return like variable life policies. Cash value may be invested in various indexes or markets, depending on the type of policy. Universal life insurance typically is less expensive than variable, but insurers may raise premiums over time.
Term Life Insurance
Term life policies are the least expensive of all the types of life insurance because they only offer a death benefit. There is no cash value associated with term life insurance. Policies only last for a predetermined term; if you don’t pass away within the term, the insurance company pays no death benefit.
For individuals looking for basic life insurance coverage without a built-in savings component who don’t plan on utilizing life insurance to grow and protect tax-advantaged wealth, term life insurance is an affordable option.
Building Your Financial Portfolio
The right life insurance plays a key role in your financial portfolio. Not only can it help provide peace of mind for you and your loved ones, it can offer unique benefits not found in other financial tools. For help deciding if variable life insurance is right for your goals,