How to Use Life Insurance as a Bank

Life insurance policies can serve purposes beyond providing a death benefit. The phrase “using life insurance as a bank” refers to leveraging the accumulated cash value within certain types of permanent life insurance policies. These policies build a savings component over time, offering policyholders a source of funds they can access during their lifetime. This approach can provide financial flexibility and liquidity, allowing individuals to manage various life expenses or opportunities.

Core Principles of Cash Value Life Insurance

Cash value in a life insurance policy represents a savings component that accumulates over the policy’s lifetime. This value grows over time, separate from the death benefit, which is the amount paid to beneficiaries upon the insured’s passing.

Cash value typically grows in two primary ways. A portion of each premium payment is allocated to the cash value account, rather than solely covering the cost of insurance and administrative fees. Additionally, this accumulated cash value earns interest or dividends, which are credited to the account, allowing the balance to increase further.

Whole life insurance is a type of permanent policy known for its guaranteed cash value growth. Premiums for whole life policies are fixed, and a set portion contributes to the cash value, which grows at a guaranteed rate determined by the insurer. Some whole life policies, particularly those from mutual insurance companies, may also pay dividends, which can further enhance cash value or be used to reduce premiums or purchase additional coverage.

Universal life insurance, another form of permanent coverage, also builds cash value but offers greater flexibility. Premiums can be adjusted within certain limits, and the cash value growth is interest-based, often tied to current market rates, though typically with a guaranteed minimum interest rate. This flexibility allows policyholders to adapt payments as their financial situation changes, potentially using accumulated cash value to cover future premiums.

The growth of the cash value is generally tax-deferred, meaning taxes are not typically owed on the earnings as they accumulate within the policy. This tax-deferred growth, combined with the ability to access funds, positions these policies as financial tools for long-term savings and liquidity.

Accessing Your Policy’s Cash Value

Policyholders have distinct methods to access the cash value accumulated within their permanent life insurance policies. These methods include taking out policy loans or making direct withdrawals from the cash value.

Policy loans involve borrowing money from the insurance company, using the policy’s cash value as collateral. The policy itself remains in force, and the loan is not considered a withdrawal of the cash value. Interest accrues on the loan balance, and policyholders can typically choose their repayment schedule, or even opt not to repay the loan at all. However, any outstanding loan balance, including accrued interest, will reduce the death benefit paid to beneficiaries upon the insured’s passing. The cash value continues to grow even with an outstanding loan, providing a unique financial leverage point.

Withdrawals, conversely, involve directly taking funds from the policy’s cash value. Unlike a loan, a withdrawal permanently reduces the policy’s cash value. This reduction directly impacts the death benefit, as the withdrawn amount lessens the funds available for beneficiaries. Withdrawals also do not require repayment, but they can diminish the policy’s long-term financial benefits and may even cause the policy to lapse if the cash value falls too low to cover ongoing policy charges.

Distinguishing between these two methods is important due to their different impacts. A policy loan is a debt against the policy’s value, allowing the cash value to continue growing, while a withdrawal removes the funds entirely.

The process for requesting either a loan or a withdrawal typically involves contacting the insurance company. Policyholders usually need to submit a formal request, often through specific forms provided by the insurer. The company will then review the request based on the policy’s terms and the available cash value. While specific documentation varies, the general steps involve verifying identity and policy details before funds are disbursed, which can take several business days to a few weeks.

Tax Considerations for Cash Value Access

The cash value component of a permanent life insurance policy offers tax advantages during its growth phase. The earnings on the cash value generally grow on a tax-deferred basis, meaning that taxes are not typically owed on the interest or dividends as they accumulate within the policy.

Policy loans taken against the cash value are generally tax-free, provided the policy remains in force. The Internal Revenue Service (IRS) typically views these as loans, not distributions of income. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount may become taxable to the extent it exceeds the premiums paid into the policy. This potential tax liability arises because the loan is then treated as a distribution that was not repaid.

Withdrawals from a cash value life insurance policy are generally treated on a “first-in, first-out” (FIFO) basis for tax purposes. This means that the portion of the withdrawal up to the total premiums paid into the policy, known as the cost basis, is typically received tax-free. Any amount withdrawn that exceeds this cost basis is considered taxable gain and is subject to ordinary income tax rates.

A significant tax consideration is the Modified Endowment Contract (MEC) designation. A life insurance policy becomes an MEC if it is overfunded with premiums beyond specific IRS limits, primarily determined by the “7-pay test.” This test essentially limits how quickly premiums can be paid into a policy in its first seven years relative to its death benefit. Once a policy is classified as an MEC, this designation is permanent and irreversible.

The tax treatment of loans and withdrawals from an MEC changes considerably. Distributions, including loans and withdrawals, from an MEC are taxed on a “last-in, first-out” (LIFO) basis. This means that earnings are considered to be withdrawn first, making them immediately taxable as ordinary income. Furthermore, if such distributions are taken before the policyholder reaches age 59½, they may also be subject to a 10% federal penalty tax, similar to rules for certain retirement accounts.