Can You Invest in Life Insurance Policies?

Life insurance is a contract between an individual and an insurer, where the company pays a death benefit to designated beneficiaries upon the insured person’s passing. This financial protection helps loved ones manage expenses and maintain stability after a loss. While the primary purpose of life insurance is to provide this death benefit, certain policies also incorporate a savings or investment component. This feature allows a portion of premiums to accumulate value over time, offering a potential financial resource during the policyholder’s lifetime.

Life Insurance Policies with Investment Components

Permanent life insurance policies are designed to offer lifelong coverage and typically include a cash value component that can grow over time. Three main types of permanent life insurance policies feature this investment-like element: whole life, universal life, and variable universal life. Each type structures the growth of its cash value differently, catering to various financial preferences and risk tolerances.

Whole Life Insurance

Whole life insurance is a straightforward form of permanent coverage providing a guaranteed death benefit and a cash value component. The cash value grows at a predetermined, guaranteed interest rate set by the insurer. This predictability means policyholders can rely on consistent cash value accumulation regardless of market fluctuations.

Universal Life (UL) Insurance

Universal life (UL) insurance offers more flexibility than whole life, allowing policyholders to adjust premium payments and death benefits within certain limits. The cash value in a universal life policy grows based on an interest rate declared by the insurer, which can fluctuate over time but often has a guaranteed minimum. This interest-sensitive growth means the cash value can potentially grow faster than in a whole life policy if market conditions are favorable, while still offering some protection against significant downturns. A specific variation, Indexed Universal Life (IUL), links its cash value growth to the performance of a stock market index, such as the S&P 500, without directly investing in the market. The growth is typically capped, and there is often a floor to protect against losses, providing a balance between market participation and principal protection.

Variable Universal Life (VUL) Insurance

Variable universal life (VUL) insurance combines the flexible premiums and death benefit features of universal life with the ability to invest the cash value directly into various sub-accounts, similar to mutual funds. The growth of the cash value in a VUL policy is directly tied to the performance of these chosen investment sub-accounts. This investment-linked growth offers the potential for higher returns, but it also carries market risk, meaning the cash value can decrease if the underlying investments perform poorly. Policyholders bear the investment risk with VUL policies, making them suitable for those comfortable with market volatility.

Understanding Cash Value Growth and Access

The cash value within permanent life insurance policies serves as an accumulating fund accessible by the policyholder during their lifetime. This value grows through various mechanisms, depending on the policy type, and offers several ways to utilize the accumulated funds. Understanding these growth methods and access options helps in using the policy’s investment component.

Accessing Cash Value

Policyholders can access the accumulated cash value during their lifetime through several methods. One common method is taking a policy loan, where the policyholder borrows money from the insurer using the cash value as collateral. These loans are typically tax-free and do not require credit checks, but they accrue interest and reduce the death benefit if not repaid. The loan interest rates are set by the insurer and can vary.

Another option is to make partial withdrawals from the cash value. This reduces both the cash value and the death benefit of the policy. Withdrawals are generally tax-free up to the amount of premiums paid into the policy, which is considered the cost basis. Any amount withdrawn exceeding the cost basis may be subject to income tax.

Lastly, a policyholder can surrender the policy entirely, canceling the coverage in exchange for the cash surrender value. The cash surrender value is the accumulated cash value minus any surrender charges and outstanding loans. Surrendering a policy terminates the death benefit and can result in taxable income if the cash surrender value exceeds the total premiums paid.

Tax Implications and Policy Costs

Understanding the tax implications and associated costs is important when considering life insurance policies with investment components. These financial aspects directly impact the net return and overall financial benefit derived from the policy’s cash value accumulation.

Tax Implications

The growth of cash value within permanent life insurance policies generally enjoys tax-deferred status. This means that earnings on the cash value are not taxed annually as they accrue. Taxes are typically only incurred when the money is withdrawn from the policy, and only on the amount that exceeds the premiums paid, which is known as the cost basis. The death benefit paid to beneficiaries is typically received income tax-free.

Accessing the cash value through policy loans is generally tax-free, provided the policy is not classified as a Modified Endowment Contract (MEC). Loans are treated as debt against the policy’s cash value, not as income. However, if a policy is surrendered or lapses with an outstanding loan, the loan amount exceeding the cost basis can become taxable. Withdrawals from a policy are tax-free up to the cost basis, but any amount exceeding this basis is typically subject to ordinary income tax.

A policy can become a Modified Endowment Contract (MEC) if it fails the “7-pay test,” meaning that premiums paid into the policy during its first seven years exceed certain limits set by the IRS. Once a policy is classified as a MEC, any loans or withdrawals are subject to “last-in, first-out” (LIFO) taxation rules, meaning earnings are considered to be withdrawn first and are subject to income tax. Additionally, withdrawals from a MEC before age 59½ may incur a 10% federal tax penalty, similar to distributions from qualified retirement plans.

Policy Costs

Permanent life insurance policies come with various costs that can impact the growth of the cash value. These costs typically include mortality charges, which cover the cost of the death benefit and are based on factors like age and health. Administrative fees are charged for policy management and record-keeping. Some policies may also include surrender charges, which are fees applied if the policy is canceled within a certain number of years, often ranging from 10 to 15 years from policy inception. For variable universal life policies, there are additional investment management fees for the underlying sub-accounts, similar to mutual fund expense ratios, which can range from 0.5% to over 2% annually.