How to Make Money With Life Insurance

Life insurance primarily provides financial security for beneficiaries after the policyholder’s passing. However, certain policies also function as dynamic financial instruments, offering cash accumulation and access during an individual’s lifetime. These policies build an internal cash value, which can be utilized for various financial needs. Understanding how these policies generate and allow access to funds reveals their potential as a flexible financial resource, extending their utility beyond a simple death benefit.

Types of Policies with Financial Components

Life insurance policies designed to build cash value offer a financial component that can be leveraged over time. These policies differ in how their cash value accumulates and the flexibility they provide.

Whole life insurance

Whole life insurance is a type of permanent life insurance featuring guaranteed cash value growth and level premiums. A portion of each premium payment is allocated to the cash value, guaranteed to grow at a predetermined rate. This predictable growth provides a reliable savings component. Participating whole life policies may also pay dividends, which can contribute to the cash value or be used in other ways.

Universal life insurance

Universal life insurance offers more flexibility than whole life, allowing policyholders to adjust premium payments and death benefits. The cash value grows based on an interest rate credited to the account. This rate can be fixed for stable growth or indexed to a financial benchmark for potential higher returns linked to market performance. Premium flexibility allows policyholders to pay more to increase cash value faster or less if financially constrained, though paying less than the cost of insurance and expenses can reduce cash value.

Variable universal life insurance

Variable universal life insurance combines universal life’s flexibility with an investment component, allowing cash value to grow based on underlying investment sub-accounts. Policyholders choose from sub-accounts, similar to mutual funds, which can include stocks, bonds, or money market instruments. This direct link to market performance offers potential for significant cash value growth but also carries investment risk, as the cash value can decrease if sub-accounts perform poorly. The death benefit may also fluctuate based on cash value performance, though often with a minimum guarantee.

Developing Policy Cash Value

Cash value accumulation within a life insurance policy is a structured process influenced by several mechanisms. These mechanisms determine how the policy’s internal savings component grows over time, with each policy type employing distinct methods.

Premium payments

Cash value develops through premium payments. For permanent life insurance policies, a portion of each premium is allocated to the cash value, after accounting for the cost of insurance and administrative fees. This consistent contribution forms the base for further growth, ensuring a steady increase in the policy’s internal savings.

Interest crediting

Interest crediting is a primary mechanism for cash value growth in universal life insurance policies. The insurer credits interest to the policy’s cash value account, often at a declared rate subject to minimum guarantees. For indexed universal life policies, interest is linked to an external market index, such as the S&P 500, without direct market investment. This method provides potential for higher returns than fixed-rate policies while offering some protection against market downturns through an interest rate floor.

Policy dividends

Policy dividends contribute to cash value growth in participating whole life insurance policies. These dividends represent a portion of the insurer’s surplus earnings returned to policyholders. While not guaranteed, dividends can be used to purchase paid-up additions. Paid-up additions are small, fully paid-for insurance policies that increase both the death benefit and the cash value, accelerating overall cash value growth.

Investment sub-accounts

For variable universal life policies, cash value growth is directly tied to the performance of chosen investment sub-accounts. Policyholders select from a range of investment options, similar to mutual funds, managed separately from the insurer’s general account. Returns generated by these sub-accounts, net of fees, are credited to the policy’s cash value. This mechanism offers potential for significant appreciation during favorable market conditions but also exposes the cash value to market risk, meaning it can decline.

Accessing Policy Funds

Accessing funds from a life insurance policy’s accumulated cash value provides financial flexibility during the policyholder’s lifetime. Several methods allow for this access, each with distinct implications for the policy’s death benefit and potential tax consequences.

Policy loan

A common method is taking a policy loan, where the policyholder borrows money directly from the insurer, using the cash value as collateral. These loans do not require credit checks or a formal repayment schedule, though interest accrues on the outstanding balance. The loan interest rate can vary, often ranging from 4% to 8% annually, and is a fixed or variable rate set by the insurer. If the loan is not repaid, the outstanding balance, plus accrued interest, will be deducted from the death benefit.

Partial withdrawals

Policyholders can also access funds through partial withdrawals from the cash value. Unlike loans, withdrawals directly reduce the policy’s cash value and the death benefit. These withdrawals are tax-free up to the amount of premiums paid into the policy, considered the policyholder’s cost basis. If the withdrawal amount exceeds total premiums paid, the excess is taxable as ordinary income. For example, if $50,000 in premiums were paid and $60,000 is withdrawn, the $10,000 gain would be taxable.

Surrendering the policy

Surrendering the policy is another way to access accumulated funds, involving complete termination of the policy in exchange for its cash surrender value. The cash surrender value is the accumulated cash value minus any surrender charges, which are fees applied if the policy is terminated within a certain period, often the first 10 to 15 years. Upon surrender, the policy ceases to exist, and the death benefit is forfeited. Any amount received exceeding total premiums paid is considered a taxable gain and is subject to ordinary income tax. For example, if a policyholder paid $100,000 in premiums and receives a surrender value of $120,000, the $20,000 gain would be taxable income.

Selling a Life Insurance Policy

Selling a life insurance policy offers an alternative way for policyholders to access a portion of their policy’s value during their lifetime, distinct from directly accessing cash value. This process, known as a life settlement, involves selling an existing life insurance policy to a third-party investor for a lump sum. The amount received is greater than the policy’s cash surrender value but less than the full death benefit.

Life settlement process

In a life settlement, the policyholder transfers policy ownership to the buyer, who assumes responsibility for paying future premiums. The buyer collects the death benefit when the insured passes away. This transaction provides immediate liquidity, beneficial for those facing significant medical expenses, needing retirement funds, or seeking to eliminate premium payments on an unwanted policy. The process begins with the policyholder contacting a licensed life settlement provider or broker to obtain an offer.

Eligibility

Eligibility for a life settlement depends on several factors, including the policyholder’s age and health status. While specific criteria vary by provider, policyholders are often aged 65 or older, or have a significant health change impacting their life expectancy. The policy itself needs to be a permanent life insurance policy, such as whole life, universal life, or variable universal life, with a minimum death benefit, often $100,000 or more, and in force for at least two to five years. The process involves policy valuation based on the death benefit, insured’s life expectancy, and future premium obligations, followed by offers from potential buyers.

Tax implications

The tax implications of life settlement proceeds are important. The Internal Revenue Service (IRS) treats the proceeds in three parts: the portion up to the policyholder’s cost basis (total premiums paid) is received tax-free. Any amount exceeding the cost basis but less than or equal to the policy’s cash surrender value is taxed as ordinary income. Furthermore, any amount exceeding both the cost basis and the cash surrender value is taxed as a capital gain. For instance, if a policyholder paid $50,000 in premiums, had a cash surrender value of $70,000, and sold the policy for $100,000, $50,000 would be tax-free, $20,000 ($70,000 – $50,000) would be ordinary income, and $30,000 ($100,000 – $70,000) would be a capital gain.