Can You Make Money on Life Insurance?

Life insurance policies primarily provide financial protection to beneficiaries upon the policyholder’s death. However, certain types of life insurance offer a component that can serve as a financial asset during the policyholder’s lifetime. This feature allows individuals to access or leverage accumulated value, providing a potential source of funds for various financial needs.

Understanding Cash Value Accumulation

Cash value is a savings or investment component within permanent life insurance policies, such as whole life, universal life, and variable universal life. A portion of each premium payment contributes to this cash value, which then grows over time on a tax-deferred basis. This accumulation is distinct from the policy’s death benefit.

In whole life insurance policies, the cash value grows at a guaranteed fixed interest rate. This predictable growth provides a stable increase in the policy’s value over its lifetime. For participating whole life policies, the cash value can also be enhanced by annual dividends, which are not guaranteed but can increase the cash value.

Universal life (UL) policies offer more flexibility in premium payments and death benefits. Their cash value growth is tied to interest rates set by the insurer or linked to market performance. UL policies typically include a guaranteed minimum interest rate, but actual growth can vary. A portion of premiums covers the cost of insurance and administrative fees, with the remainder contributing to the cash value.

Variable universal life (VUL) policies allow policyholders to allocate the cash value to various sub-accounts. The growth or decline of the cash value in VUL policies depends directly on the performance of these underlying investments, introducing both higher potential returns and greater risk. Indexed universal life (IUL) policies, a variation of UL, tie cash value growth to the performance of a specific stock market index, such as the S&P 500.

Accessing Policy Cash Value

Policyholders can access the accumulated cash value within their permanent life insurance policies through several methods, providing a financial resource. These options include policy loans, withdrawals, partial surrenders, and full surrenders.

Policy loans allow policyholders to borrow money against their policy’s cash value, using the policy as collateral. No application or credit check is required. Interest rates are typically lower than personal loans. While repayment is flexible, any outstanding loan balance, including accrued interest, will reduce the death benefit if not repaid. If the loan balance grows to exceed the cash value, the policy can lapse, potentially leading to a tax liability.

Withdrawals involve directly taking funds from the cash value, which reduces both the cash value and the death benefit. Unlike loans, withdrawals do not need to be repaid. However, withdrawing funds can diminish the financial protection for beneficiaries and affect the policy’s future growth. Withdrawals exceeding total premiums paid may be subject to taxation on the gains.

Partial surrenders involve canceling a portion of the policy’s coverage in exchange for a portion of its cash value. This action directly reduces the death benefit proportionally. This method allows access to funds while maintaining some coverage, but it permanently alters the policy’s structure.

A full surrender involves canceling the entire life insurance policy in exchange for its cash surrender value. The cash surrender value is the accumulated cash value minus any applicable surrender charges, outstanding loans, or past withdrawals. This action terminates the policy, ending all coverage and the death benefit. Surrender charges are fees levied by the insurance company for canceling the policy early.

Leveraging Life Insurance for Financial Strategies

The cash value in permanent life insurance policies can be strategically leveraged as a financial tool within a broader financial plan. For participating policies, particularly whole life, policyholders may receive dividends. These dividends are not guaranteed but represent a portion of the insurer’s profits returned to policyholders. Policyholders have several options for using these dividends:
Receive them as a cash payment.
Use them to reduce future premium payments.
Allow them to accumulate with interest within the policy.
Use them to purchase “paid-up additions,” which are small, single-premium policies that add to both the policy’s cash value and its death benefit. This accelerates cash value growth and increases the overall death benefit.

The cash value can also be used as collateral to secure external loans from banks. This is known as a collateral assignment of life insurance. Lenders often view life insurance cash value as favorable collateral due to its stability, which can lead to more favorable loan terms. If the policyholder passes away before the loan is repaid, the lender is repaid from the policy’s death benefit before any remaining funds are distributed to beneficiaries. This strategy allows policyholders to access liquidity without directly impacting the policy’s cash value.

Furthermore, with careful planning, the cash value can serve as a supplemental income source during retirement. This can involve a planned series of withdrawals or policy loans. While policy loans do not directly reduce the cash value, they create a lien against the death benefit. Planned withdrawals reduce the cash value directly. Both methods require careful management to ensure the policy remains in force and does not lapse prematurely, which would have tax implications.

Key Considerations and Tax Implications

Understanding the practical implications and tax rules is essential when considering life insurance as a financial tool. The way cash value is accessed significantly affects its tax treatment and the policy’s long-term viability.

The taxation of cash value access varies by method. Policy loans are generally tax-free because they are viewed as borrowing against an asset. However, if a policy lapses or is surrendered with an outstanding loan, the amount of the loan exceeding premiums paid can become taxable income. Interest on policy loans is typically not tax-deductible.

Withdrawals from cash value are generally tax-free up to the amount of premiums paid into the policy, considered a return of principal. Any amount withdrawn exceeding total premiums paid is taxable income. This “first-in, first-out” (FIFO) tax treatment means basis (premiums paid) is assumed to be withdrawn first, then gains.

Full surrenders of a policy for its cash value can result in taxable income if the cash surrender value received exceeds the total premiums paid. The difference is taxed as ordinary income. Surrender charges are deducted from the cash value when a policy is surrendered early.

A Modified Endowment Contract (MEC) designation is a consideration. A life insurance policy becomes an MEC if it is overfunded relative to IRS guidelines. Once classified as an MEC, its tax treatment changes permanently, becoming less favorable. Withdrawals and loans from an MEC are taxed on a “last-in, first-out” (LIFO) basis, meaning gains are taxed first as ordinary income. Withdrawals or loans from an MEC taken before age 59½ may be subject to a 10% federal penalty tax.

Accessing cash value, particularly through withdrawals or unpaid loans, directly reduces the death benefit. This can diminish the primary purpose of the policy: providing financial security for loved ones. Cash value growth takes time, and early access may not be optimal due to slower accumulation and potential surrender charges. If loans or withdrawals deplete the cash value too much, the policy could lapse if there are insufficient funds to cover policy charges, leading to loss of coverage and potential tax liabilities. Consulting with a qualified financial advisor or tax professional is advisable to understand these complexities.