Does a Paid-Up Life Insurance Policy Earn Interest?

A paid-up life insurance policy requires no further premium payments, yet continues to provide a death benefit. While these policies don’t earn “interest” like a savings account, their value grows through specific internal mechanisms.

Defining Paid-Up Life Insurance

A paid-up life insurance policy signifies all required premiums have been satisfied, and the policy remains in force without additional payments. This status primarily applies to whole life insurance, a permanent type of life insurance. Unlike term life, whole life policies build cash value over time and offer a guaranteed death benefit.

A policy can become paid-up by completing its original premium schedule (e.g., over 10 or 20 years, or until a certain age). Policyholders can also use accumulated cash value or dividends to purchase “paid-up additions.” These additions are small, single-premium policies that increase both the death benefit and cash value of the original policy.

Value Accumulation in Paid-Up Policies

Paid-up life insurance policies do not earn “interest” like a bank account. Instead, they accumulate value through cash value growth and, for participating policies, dividends. The cash value component includes a guaranteed growth rate, ensuring predictable increases. This growth compounds annually, building value even after premium payments cease.

Mutual insurance companies may issue dividends, representing a portion of surplus earnings. Dividends are not guaranteed and fluctuate based on insurer performance. Policyholders can use dividends to:
Receive cash.
Reduce future premiums.
Purchase paid-up additions.
Purchasing paid-up additions is a common strategy, enhancing both the policy’s cash value and death benefit.

Utilizing Your Policy’s Accumulated Value

The accumulated cash value in a paid-up life insurance policy offers financial flexibility. Policyholders can access this value through policy loans, borrowing against the cash value. Loans accrue interest; if unpaid, they reduce the death benefit. Loan interest rates typically range from 5% to 8% annually.

Partial withdrawals are another option, directly reducing the cash value and proportionally decreasing the death benefit. Policyholders can also surrender the policy for its cash surrender value (cash value minus charges or outstanding loans). This action terminates the policy and its death benefit.

Whole life policies also offer non-forfeiture options if premium payments stop or the policy is discontinued. These options allow using accumulated cash value to:
Purchase a reduced paid-up policy, providing a lower death benefit with no further premiums.
Obtain extended term insurance, providing the original death benefit for a limited period.

Tax Considerations for Paid-Up Policies

The tax treatment of paid-up life insurance policies is favorable. Cash value growth is typically tax-deferred; taxes on earnings are not due until funds are withdrawn or the policy is surrendered. This allows cash value to grow more efficiently.

Upon the policyholder’s death, the death benefit paid to beneficiaries is generally income tax-free. Policy loans against cash value are also generally tax-free, provided the policy remains in force and is not classified as a Modified Endowment Contract (MEC).

Withdrawals are typically taxed on a “first-in, first-out” (FIFO) basis, meaning the cost basis (premiums paid) is withdrawn first, tax-free. Only gains are taxed. If a policy is surrendered and the cash surrender value exceeds total premiums paid, the gain is taxable income. Dividends are generally considered a return of premium and are tax-free until they exceed total premiums paid; any excess may be taxable. If a policy is classified as a MEC due to overfunding, distributions (including loans and withdrawals) may be taxed differently, often on a “last-in, first-out” (LIFO) basis, with gains taxed first and potentially subject to penalties if withdrawn before age 59½.