Permanent or cash-value life insurance policies can be fantastic tools for providing tax-free cash. They're truly one of the great tax management tools of our times. That is, as long as you use them correctly. Used incorrectly, they’re unlikely to provide a significant tax advantage or even significant value.
Permanent policies are often used for funding education and other accumulation goals. These living benefits, accessing cash value accumulation during the insured’s lifetime, are a primary reason to use these tools.
Term life insurance is for a temporary period (its term) and accrues no cash value. Whole life, universal life, and variable universal life are all permanent policies — they're designed to last the lifetime of the insured.
Permanent Policy Basics
Cash-value policies have a face amount. This is the policy’s death benefit. The death benefit is payable to the beneficiaries upon the death of the insured.
Permanent policies provide a significant advantage that term insurance can't: They can last a person’s entire life, even if the person lives to a ripe old age. Term insurance generally won’t go past about age 70, so you lose it when you’re close to collecting.
A caveat about how long permanent policies remain in force: Many of the permanent policies that were sold in the past matured at age 95 or 100. This means that at the given age — the policy’s maturity date — the insurance company paid out the death benefit as if you had died. The catch? If you’re not dead, it’s a taxable event.
Newer permanent policies either use age 120 for maturity or have an extension mechanism to extend past a scheduled maturity of 95 or 100.
Policies can be either participating or nonparticipating. A participating policy, issued by a mutually owned insurance company, can receive dividends. A dividend is a return of premiums collected. A nonparticipating policy isn't eligible to receive dividends.
All policies issued by stock insurance companies are nonparticipating, but mutual companies may also issue nonparticipating policies. The bottom line: If an agent shows you a schedule of future dividends, be aware they are not guaranteed and might not materialize. It's great if they do, but don’t bank on it.
There are a lot of variations in policy specifics. For example, some require you to pay premiums for only a set period of time, while others don't. There are many other features, as well. However, we’ll stick to the typical formats that you will find most often.
Whole Life Insurance
Whole life is the oldest form of permanent insurance. It provides a death benefit for your life with level premiums.
Whole life’s strength is in its guarantees. As long as you pay the premiums, the policy stays in force. The cash-value growth is pretty slow, and these policies tend to lack flexibility.
They generally don’t allow for partial surrenders, which makes policy loans the only mechanism to access cash values. This is a disadvantage, as we’ll discuss shortly.
Universal Life Insurance
Universal life is a later form of permanent insurance. You pay a premium and have a death benefit, much like whole life. However, you have a lot more flexibility. You can increase or decrease premiums, make partial surrenders, or take out loans.
When you make payments, your premium is allocated to policy costs, then the cost of insurance, then cash value. The amount of insurance you pay for is the difference between the policy’s death benefit and the policy’s cash value. So as your cash value increases, you have less insurance to purchase. But the insurance you do purchase is based upon age, so the cost for each unit of insurance increases as you age.
The flexibility that allows you to do a lot with the policy can also get you into trouble. The policy has guarantees as long as you pay a certain level of premium. If you pay less than that, you can lose some of the policy’s guarantees and end up needing to increase your premium outlays to keep the policy in force.
The advantage over whole life is flexibility and the ability to access cash value — to an extent — through partial surrenders instead of loans. If you don’t pay enough premium into the policy, you can lose some guarantees. If you're using the policy to accumulate for a goal such as education or retirement, you should be amply funding the policy and not have any issues with this.
As with whole life, the returns for universal life insurance are weak.
Universal life pays a “competitive” interest rate. Unfortunately, that will never actually be good.
In times like today, it will be very low. In times of high inflation, it will seem high, but generally still not very good compared with inflation. Most policies guarantee a minimum interest — better than most savings accounts but still weak.
Variable Universal Life
Variable universal life is a universal life policy with additional investment options. In addition to the fixed account of a traditional universal life, you have a number of investment options including stock accounts, bond accounts — typically a number of choices so you can allocate your cash value across markets and change your allocation as your needs change.
Variable universal life solves the major drawback of universal life in that it allows for management of the cash value beyond the CD-like fixed account. In exchange, you pick up one more element of risk. Now your cash value can actually go down as well as up; you can have market risk in your policy’s cash value.
Your Life Insurance Policy’s Tax Basis
Your policy has a basis for tax purposes. Heirs receive the death benefit tax-free, but what if you cancel the policy after a certain number of years?
Distributions from the policy (other than the death benefit) are taxable to the extent the distribution exceeds the policy’s basis. The basis is the sum of all your payments into the policy minus distributions, other than loans, made back to you. These could be dividends or prior partial surrenders, either of which reduces your basis.
Taxation of Policy Proceeds
Life insurance is a tax-favored investment vehicle. The general way taxation works is that you get no up-front tax breaks (no deductibility), but your cash value grows tax-deferred. The death benefit is then tax-free to your heirs. There are some exceptions: Overfunding an insurance policy can cost you some of your favorable tax treatment. The rules are clear, and your agent can let you know exactly where the limits are.
But we’re interested in the living benefits — how to take money out without dying.
There are two ways to access cash value while the policy is still in force: loans and partial surrenders.
A policy loan reduces the cash value by the amount you borrow. You pay the loan back, with interest. While the specifics vary from policy to policy, generally you are credited with most or all of the interest you pay. Loans aren’t taxable. Excellent — we have a way to get at the money without paying tax.
But you will either have to pay the loan back or leave it in place and it will be paid from the death benefit, reducing the amount your heirs receive. And that could be a long way off. It would be great if there were a better way to access the cash value.
Universal and variable universal life policies generally allow for partial surrenders. A partial surrender reduces both the death benefit and the cash value by the amount of the surrender.
For example, say you have a policy with a $500,000 death benefit and $200,000 in cash value. A partial surrender of $50,000 would reduce your death benefit to $450,000 and your cash value to $150,000. And it’s taxable only if it exceeds the policy’s cost basis. Insurance companies typically charge a small fee for each partial surrender.
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Surrender to Basis, Switch to Loans
This is your cash-access mantra as a permanent policyholder. You take the money for your goals via partial surrenders until you have surrendered the basis to zero or nearly so. Then you switch to loans for additional access.
Many whole life policies don’t allow for partial surrenders. In that case, loans are your only option. This is a big disadvantage from an accumulation vehicle standpoint. It really puts a big constraint on your access to the cash.
If a policy lapses, any outstanding loan becomes taxable to the extent it exceeds the policy’s basis at the time. Be very careful to keep any policy with an outstanding loan in force until the loan is paid or the insured dies.
Caution Is the Buzzword
Agents make a lot of money selling life insurance. They have a vested interest in your buying a policy. A big interest.
The policies are very powerful. No other vehicle provides these unique tax advantages. But they are not for everyone. You are paying for insurance — for a death benefit. If you don’t need insurance, the policies probably won’t make sense.
But if you are raising children there’s a good chance you do need insurance. And a fantastic way to get tax-free money at the time you need it most: when tuition is due.
Sometimes agents recommend putting a permanent policy in place on a young child for the purpose of education accumulation. This generally doesn’t work. The premiums are too low to allow for any significant cash value accumulation by the time the child reaches college age.
Look carefully at any illustrations — specifically at the projected cash values at the time when you might need the money. If the insured person is a minor, you’ll find there’s very little cash value by the time they’re 18 or 20. It’s almost never a good idea.
Life Insurance and Taxes: Wrapping It All Up
Insurance isn’t for everyone. But permanent policies offer a rare opportunity to accumulate money tax-deferred and possibly to spend some of it tax-free.
These are complex and powerful investment vehicles. Complex and powerful things can do wonders for you if used correctly, they can cause major problems if used incorrectly.
It behooves you to work with someone knowledgeable to maximize the benefits and minimize the risk. Used properly, permanent insurance policies can accomplish things no other investment vehicles can.