Life Insurance Cash Value: Safe From Government Seizure?

Life insurance policies can be of two types: term life and permanent life. Term life insurance lasts for a specific period, usually 20 years, and offers only a death benefit to the beneficiaries. On the other hand, permanent life insurance lasts for the entire life of the insured or until they reach the age of 99, depending on the policy. Permanent life insurance policies, such as whole life and universal life, can accumulate a cash value that the policyholder can use for various purposes, including borrowing, withdrawing cash, or paying policy premiums. This cash value grows tax-free over time, providing a financial asset for the policyholder. However, if the cash value is not utilised before the policyholder's death, it typically reverts to the insurance company instead of the beneficiaries.

Borrowing from the cash value

Firstly, it is important to note that you can only borrow against a permanent life insurance policy, such as a whole life insurance or universal life insurance policy. Term life insurance, which is cheaper and more suitable for many people, does not have a cash value and is designed to last for a limited period, typically anywhere from one to 30 years. However, in some cases, a term life policy can be converted into a permanent policy where cash value can build up.

When you borrow from a life insurance policy, you are essentially borrowing from yourself, with the cash in your policy acting as collateral. This means there is no impact on your credit score, no approval process or credit check, and no requirement to explain how you plan to use the money. The loan is also not recognised as income by the IRS, so it remains tax-free as long as the policy stays active.

It is important to understand the potential downsides of borrowing from your life insurance policy. Any money borrowed will need to be paid back with interest, and there is no mandatory monthly payment. If the loan is not repaid, the interest will be added to the balance and will continue to accrue, potentially causing the policy to lapse. In this case, you may owe taxes on the borrowed amount. Additionally, a policy loan reduces your available cash value and death benefit. If you pass away while still owing money on the loan, your beneficiaries will receive a reduced amount.

The time it takes for the cash value to build up in a life insurance policy can vary depending on the type of policy. Some policies may take several years to accrue sufficient cash value to borrow against. It is recommended to consult a financial advisor to weigh the pros and cons before deciding to borrow from your life insurance policy.

Withdrawing the cash value

However, before withdrawing the cash value, it is essential to consider the potential consequences. Withdrawing cash from your life insurance policy will reduce the death benefit, resulting in a smaller payout for your beneficiaries when you pass away. Therefore, it is crucial to carefully weigh your need for immediate cash against the long-term financial security of your loved ones.

Additionally, it is important to understand the tax implications of withdrawing cash from your life insurance policy. If you withdraw an amount exceeding the sum you have paid in premiums, you will likely owe income tax on the earnings. This is because the Internal Revenue Service (IRS) considers withdrawals up to your basis (the amount you've paid in premiums) as a return of your investment and, therefore, exempt from taxation. However, any amount withdrawn above your basis is treated as taxable income.

Furthermore, it is worth noting that different types of life insurance policies have varying rules regarding cash withdrawals. For instance, whole life insurance offers a fixed premium, death benefit, and interest rate, providing predictability but limited flexibility. On the other hand, universal life insurance allows for adjustments to premiums and death benefits within certain limits and offers the potential for higher returns through market interest rates. Understanding the specifics of your policy is crucial before making any withdrawals.

Lastly, consulting a financial advisor or tax professional before withdrawing the cash value from your life insurance policy is highly recommended. They can provide personalized advice and help you navigate the potential consequences, ensuring you make an informed decision that aligns with your financial goals and obligations.

Surrendering the policy

Surrendering your life insurance policy means cancelling your coverage and receiving a payout from your insurance company. This payout is known as the cash surrender value and is the cash value of your policy minus any surrender fees and taxes on earnings. Surrender fees typically range from 10-35% and are usually highest in the early years of the policy.

When you surrender your policy, you will lose coverage and no longer be responsible for paying insurance premiums. However, you will also lose the death benefit, which will no longer be paid out to your beneficiaries when you pass away.

There are several reasons why someone might choose to surrender their life insurance policy. These include:

• No longer needing coverage, for example, if children have grown up and become financially independent.
• The policy becoming too expensive.
• Finding a better policy that offers improved coverage or cheaper premiums.
• Needing cash, either for an emergency or to invest in something else.

Surrendering your policy is a significant decision that will impact both you and your family, so it is important to carefully consider the pros and cons.

Pros of Surrendering Your Life Insurance Policy:

• It is a simple and fast process. You just need to contact your insurance company and let them know you would like to surrender the policy.
• You will get some money back, which is better than nothing if you are no longer able to pay the premiums.

Cons of Surrendering Your Life Insurance Policy:

• You will only get one offer from the insurance company, and it will likely be a low offer as their goal is to pay out as little as possible.
• There may be surrender fees, which can be as high as 10-35% of the cash value.
• You will lose the death benefit, which could be important for your family's financial future.
• You may face unexpected tax consequences. The gain on your policy will be taxed as income, and you may also have to pay taxes on the surrender value if earnings exceed the amount you have paid into the policy.

If you are considering surrendering your life insurance policy, it is important to weigh up the pros and cons and, if possible, explore alternative options such as selling your policy or taking out a loan. A financial advisor can help you understand all the potential consequences of surrendering your policy and ensure you make the best decision for your circumstances.

Using the cash value to pay premiums

Permanent life insurance policies such as whole life and universal life insurance can accumulate a cash value over time. This cash value can be used to pay premiums, but it's important to note that permanent life insurance policies are more expensive than term life insurance policies. This is because a portion of each premium payment goes towards the cost of insurance, while the remainder is deposited into a cash value account.

If you build up enough money in your cash value account, you may be able to use it to cover premium payments. This can be helpful if you're struggling to make payments or if you need to reduce expenses after retiring. It's important to talk to your insurance agent to understand the rules around this.

When you make a premium payment for cash value life insurance, the payment is split three ways: into the policy's cash value, to the insurer's cost of providing the death benefit, and toward life insurance company fees and charges. Only a portion of what you pay winds up in the cash value, and this portion grows based on a fixed amount, investment gains, or both.

If you decide to use your cash value to pay premiums, any amount taken from your cash value account that isn't repaid before your death will reduce the death benefit paid to your beneficiary. It's also important to note that the way you access your cash value will impact the amount available to you, your death benefit, and your account's growth.

Increasing the death benefit

When you buy life insurance, you can choose the size of the death benefit that will go to your heirs when you pass away. While some policies keep the same amount for the duration of the policy, others give you the option to increase the death benefit over time. This means that you can build a larger payout for your heirs, which usually comes with a more expensive premium.

Universal life insurance offers two primary choices. The level death benefit, sometimes called Option 1, maintains the same death benefit throughout the life of the policy. The increasing death benefit (Option 2) allows the death benefit to rise as the cash value of the policy increases over the years. Most universal life policies allow owners to switch between level and increasing death benefits with few restrictions.

Whole life insurance policies produce dividends that can be used to purchase additional coverage, thus increasing the death benefit. Whole life policies can also be written so that the cash value is used to increase the death benefit.

Some term life insurance policies also offer increasing death benefits. When you sign up, you select the insurance term for coverage, such as five or 20 years. Over this period, you will see how much the death benefit increases over time, and your premiums will also increase along with the extra coverage.

For a universal life policy with an increasing death benefit, the beneficiary receives the insurance proceeds plus any accumulated cash value. The more the policy owner pays into the cash value, the larger the death benefit they will leave to their heirs. Universal life policies also earn interest on the cash value, which further increases the account value and the future death benefit.

Whole life policies differ in that dividends can be used to buy additional insurance. This increases the death benefit by small increments as additional insurance is purchased each year.

When you sign up for a term policy with an increasing death benefit, the insurance company will show you how much the death benefit will increase over time. The insurer will also show how much your premium will increase throughout your coverage.

There are a variety of reasons why you might want to choose an increasing death benefit over a level death benefit. For example, you may temporarily need a higher amount of insurance, especially when you're younger and the cost of insurance is lower. You can later switch back to a less expensive, level death benefit policy.

You may also need a death benefit that will continue to increase if insurance is being used as part of a business succession plan, as level death benefit coverage may not keep up with the value of a growing business.

Additionally, you may want to rapidly build cash value by overfunding the policy in the early years after purchasing coverage. In this case, you might need an increasing death benefit policy to avoid turning your life insurance into a modified endowment contract (MEC), which removes the tax benefits of life insurance cash value. A policy becomes an MEC if the amount of premium paid exceeds the seven-pay test without an increasing death benefit.

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