Life Insurance: A Smart Investment Strategy?

Life insurance is often purchased to provide financial security for loved ones after the policyholder's death. However, some life insurance policies can also serve as an investment vehicle, allowing the policyholder to build cash value over time and access it during their lifetime. This aspect makes life insurance similar to other financial assets like IRAs or mutual funds.

There are two main types of life insurance: term and permanent. Term life insurance covers the policyholder for a set period, such as 20 or 30 years, and is generally more affordable. On the other hand, permanent life insurance covers the policyholder for their entire life as long as premiums are paid and includes a cash value component that grows tax-free. This cash value can be borrowed against, withdrawn, or used as collateral for a loan.

While permanent life insurance offers investment opportunities, it may not be the best option for everyone. It tends to have higher premiums, and there are alternative investment choices, such as stocks and bonds, that financial advisors argue may provide better returns. Additionally, permanent life insurance may be more suitable for high-net-worth individuals looking to minimise estate taxes or those who have already maximised their contributions to other tax-advantaged accounts, such as 401(k)s and IRAs.

Life insurance can be used as a financial asset during your life

There are two main types of permanent life insurance that can be used as an asset: whole life insurance and universal life insurance. Whole life insurance is the most common type of permanent life insurance, which, in addition to a death benefit, offers the policyholder the ability to accumulate cash value. A portion of the premium you’ll pay every month goes into a cash value account. Your cash value will accumulate over time at a minimum guaranteed rate indicated by your policy. The premiums on these policies typically won’t increase over the life of the policy.

Universal life insurance functions similarly to whole life – it allows policyholders to grow an asset by accruing interest over time that can be borrowed against. However, with universal life policies, the premiums aren’t set, which means they are subject to change, and there’s also no guarantee on the rate your money will earn over time. Under the universal life umbrella is something called “variable universal life insurance,” which enables policy owners to invest their earnings into the accounts of their choosing (including mutual funds), so you have the potential to earn more over time.

• Take a loan from your policy: You can borrow against the cash value of your permanent life insurance policy. Just read the fine print if you go this route. The interest rate can be fixed or variable, and it is set by the insurer. Also, if you take a loan against your policy and it’s not paid off at the time of your death, any outstanding balance that you owe gets subtracted from what your beneficiaries inherit.
• Use your policy as collateral for a loan: In some situations, you can use your life insurance policy as collateral for a loan, which can make it easier for you to get approved or perhaps get you a better rate on the loan you’re taking out.
• Withdraw funds: Rather than taking a loan that must be paid back, you can also simply make withdrawals from your policy that are yours to keep – just note that, if your withdrawal is an amount large enough to dip into your investment gains, you’ll need to pay taxes.
• Option for “accelerated” benefits: Some policies enable you to receive your benefits during your lifetime should an unexpected or extreme medical emergency arise, such as cancer, a heart attack or kidney failure. Most policies with this option allow you to withdraw anywhere from 25% to 100% of your policy’s value.
• Surrender the policy (cash out): To say that you’re “surrendering” a policy is simply another way of saying you’re canceling your coverage. When you do this, you get back the cash value you put in, less any fees your insurance company may charge. Just study the fine print carefully, because in some cases, those fees may be quite high.

Life insurance has a cash value component that grows tax-free

Permanent life insurance policies, such as whole life and universal life insurance, have a cash value component that grows tax-free. This means that the cash value in your life insurance policy is not subject to taxes until you withdraw it. This can be an attractive feature for those looking to build a nest egg over several decades, in addition to their retirement plans.

The cash value in a life insurance policy is built up over time as a portion of your premium payments. This money is deposited into an interest-bearing savings account, where it grows with tax-deferred status. The interest rates on these accounts can be fixed or variable, depending on the insurer. It's important to note that the cash value component is separate from the death benefit, which remains unchanged.

There are several ways to access the cash value of your life insurance policy. You can take out a loan against the cash value, with the interest rate set by the insurer. You can also make withdrawals from the policy, but this may be limited by the insurer and will reduce the death benefit. Additionally, if you withdraw more than the total premiums paid, the gains may be taxed as ordinary income. Finally, you can surrender or cancel the policy and receive the cash value, minus any fees or charges.

While the cash value component of life insurance can provide financial benefits, it's important to consider the potential downsides. Permanent life insurance policies with a cash value component tend to have higher premiums than term life insurance policies. Additionally, it can take several years for the cash value to accumulate, and there may be penalties for early withdrawals.

In conclusion, life insurance policies with a cash value component that grows tax-free can be a valuable tool for those looking to build long-term savings. However, it's important to carefully consider the features and limitations of these policies before making a decision.

Life insurance can be used to provide benefits during retirement

Income Source:

The cash value within a permanent life insurance policy can serve as a source of income during retirement. This value is the balance remaining after a portion of the premium payment is allocated to insurance costs. Over time, the cash-value account grows and can be withdrawn tax-free, provided the amount doesn't exceed the total premiums paid. This feature provides a source of income to maintain one's lifestyle during retirement.

Borrowing:

Life insurance policies with cash value allow individuals to borrow from their future selves. Borrowing against the cash value can provide funds during retirement, though it accrues interest and is deducted from the death benefit payable to beneficiaries. This option offers flexibility in accessing funds without a strict repayment requirement.

Premium Payments:

For permanent life insurance policies, the accumulated cash value can be used to pay upcoming policy premiums. This feature helps individuals manage their budget during retirement by utilising the policy's cash value instead of their regular income or savings for premium payments.

Emergency Fund:

The savings from opting for term life insurance over permanent life insurance can be used to build an emergency fund. This fund can cover unexpected expenses during retirement, allowing individuals to maintain their regular retirement contributions.

Disability Coverage:

In addition to life insurance, disability insurance can be crucial during retirement. It can replace lost income if an individual becomes unable to work due to a disability. While some may have disability coverage through their employer, purchasing a private policy can ensure adequate protection during retirement.

While life insurance can provide benefits during retirement, it is important to consider the specific circumstances, such as income, debt, estate planning, and family situation, to determine if maintaining life insurance coverage during retirement is necessary.

Life insurance can be used as collateral for a loan

Life insurance can be a financial asset during your life, just like an IRA or mutual fund. Permanent life insurance policies, such as whole life insurance, let you build cash value with each premium payment. Once your policy grows large enough, you can borrow against it. This is known as a collateral assignment of life insurance.

Collateral assignment of life insurance involves using your life insurance policy's death benefit as loan collateral. In other words, if you can't repay what you owe, the lender has the right to collect the collateral amount from your policy. This means that your beneficiaries will receive a reduced death benefit payout.

Here's how to apply for collateral assignment of life insurance:

• Know the requirements: Lenders generally require an active life insurance policy with cash value. This means that a term life insurance policy may not qualify. However, exact requirements vary by lender.
• Fill out a life insurance application: Apply for life insurance that will meet a lender's loan requirements. Check with the lender to see if the policy you're approved for qualifies for a life insurance collateral assignment before signing the contract.
• Fill out a collateral assignment form: Once you sign your life insurance contract and pay your first premiums, complete a collateral assignment form with your insurer. You'll need to fill in your lender's contact details so your insurer can designate them as a collateral assignee while your loan is outstanding.
• Sign and submit the form: After completing the collateral assignment form, you and your lender must sign it. Your insurer may be able to provide electronic versions of the documents and e-signature capabilities to streamline the process.

Using your life insurance policy as collateral may impact your beneficiaries if you default on the loan or pass away with an outstanding balance. Remember that if you take out a loan using your life insurance policy as collateral, any outstanding balance that you owe will be subtracted from the death benefit paid to your beneficiaries.

Collateral assignment of life insurance is most common and is often a requirement in small business lending. It can be a good option for borrowing a significant amount of money at favourable rates and terms. However, it's important to remember the potential risks. If you default on the loan or pass away with an outstanding balance, your beneficiaries will receive a reduced death benefit payout.

Life insurance can be used to pay for long-term care

Combination (Life/Long-Term Care) Products

Some insurance companies offer combination products that merge life insurance with long-term care insurance. With these policies, benefits will always be paid out in one form or another. The amount of the long-term care benefit is often expressed as a percentage of the life insurance benefit. These products are relatively new and still evolving, so the features may vary.

Accelerated Death Benefits (ADBs)

Accelerated Death Benefits are a feature included in some life insurance policies that allows you to receive a tax-free advance on your life insurance death benefit while you are still alive. This can be useful if you need funds for long-term care services. The amount you receive varies, but typically, the accelerated benefit payment is capped at 50% of the death benefit. It's important to note that using ADBs will reduce the amount paid to your beneficiaries when you pass away.

Viatical Settlements

Viatical settlements allow you to sell your life insurance policy to a third party if you are terminally ill. The viatical company pays you a percentage of the death benefit based on your life expectancy and takes over premium payments. You get money to pay for long-term care, and the company receives the full death benefit after your death. Money received from a viatical settlement is usually tax-free if you meet certain conditions. However, it's important to consider that your life insurance policy will not pay a death benefit to your heirs after a viatical settlement.

Sell a Policy for a Life Settlement

With a life settlement, you can sell your life insurance policy to a third party for its market value and use the proceeds to fund long-term care. This option is available for various types of life insurance policies, including permanent, term, and group insurance. Most companies require a minimum death benefit of $50,000. The amount you receive depends on your life expectancy, with a shorter life expectancy generally resulting in a larger percentage of the death benefit.

Set Up a Living Benefit Program

A living benefit program allows you to receive a lump sum payment, typically up to 50% of your life insurance policy's death benefit, while still reserving some death benefits for your family. This option works with different types of life insurance policies and does not require additional assets or a credit check. However, it's important to note that a living benefit is essentially a loan against the policy, and the entire loan, including interest, must be repaid or deducted from the death benefit.

Surrender the Life Insurance Policy for Cash Value

When you surrender a life insurance policy, you give up ownership and the death benefit. If the policy has accumulated cash value, the insurance company will pay you the full amount. However, you may have to pay taxes on that amount, depending on whether the cash value exceeds the cumulative premium amount paid over the life of the policy.

Take a Loan from Cash Accumulation

You can take a loan from the cash value of your life insurance policy to pay for long-term care. This option allows you to access most of the cash value, which you then pay back to yourself with interest. However, if your healthcare needs exceed the amount available, you may need to surrender the policy to access all the funds.

Use Cash Value to Fund a New Long-Term Care Policy

If you have time to plan, you can use a 1035 exchange to transfer the cash value of an existing life insurance policy to a new policy, such as a hybrid policy that includes life insurance, long-term care benefits, and living benefits for other costs. This option allows you to fund long-term care insurance without dipping into your household income.

Frequently asked questions