How to Use Life Insurance as an Investment

Life insurance policies offer financial protection for beneficiaries. Some policies also accumulate cash value over time, which can be accessed during the policyholder’s lifetime as a financial resource. This article explores how these policies build and utilize cash value.

Types of Cash Value Life Insurance

Several life insurance policies build cash value, unlike term life which provides coverage for a set period without value accumulation.

Whole life insurance offers guaranteed cash value growth, fixed premiums, and a death benefit.

Universal life insurance provides flexibility regarding premiums and death benefits. Its cash value grows based on an interest rate declared by the insurer, which can fluctuate but includes a minimum guaranteed rate.

Variable universal life insurance links cash value growth to the performance of investment sub-accounts chosen by the policyholder. These sub-accounts are like mutual funds, offering potential for higher returns but carrying market risk; cash value can decrease with poor investment performance.

Indexed universal life insurance ties cash value growth to a market index without direct investment. The policy includes a participation rate and a cap, limiting the maximum return. A floor protects against market downturns, ensuring no cash value loss.

Term life insurance is for protection and does not build cash value. It provides coverage for a set term.

How Cash Value Accumulates

Cash value within a permanent life insurance policy accumulates from a portion of each premium payment. After accounting for policy charges like cost of insurance, administrative fees, and riders, the remainder is allocated to cash value.

The accumulated cash value forms the basis for the policy’s surrender value. If a policyholder cancels their policy, the surrender value is cash value minus surrender charges.

Strategies for Utilizing Cash Value

One method is a policy loan, borrowing money from the insurer using cash value as collateral. These loans accrue interest but have no fixed repayment schedule.

Unpaid policy loans, including accrued interest, reduce the death benefit. If the outstanding loan plus interest exceeds cash value, the policy can lapse, creating a taxable event. Monitor policy loans to prevent this.

Withdrawing a portion of cash value permanently reduces the policy’s death benefit. Withdrawals are tax-free up to the amount of premiums paid (the cost basis). Amounts exceeding this basis are taxed as ordinary income.

When surrendered, the insurer pays the cash surrender value, which is the cash value minus surrender charges and outstanding loans. This terminates the policy and its death benefit; any gain over the cost basis may be subject to ordinary income tax.

This strategy is useful later in life, especially if income decreases or out-of-pocket payments are no longer desired. Using cash value helps maintain the policy, preserving the death benefit and continued cash value growth.

Tax Implications of Cash Value Policies

Cash value within a permanent life insurance policy grows on a tax-deferred basis, meaning policyholders do not pay taxes on annual gains as cash value accumulates. Taxes apply only when money is withdrawn or the policy is surrendered, subject to specific rules.

Policy loans against cash value are tax-free, viewed as debt. The IRS does not tax loan proceeds unless the policy lapses or is surrendered with an outstanding loan exceeding the policy’s cost basis. In such instances, the outstanding loan amount, up to the gain, may become taxable income.

Withdrawals from a cash value policy are tax-free up to the amount of premiums paid (the policyholder’s cost basis). Amounts withdrawn exceeding premiums paid are taxed as ordinary income, following the “last-in, first-out” (LIFO) accounting method.

A tax consideration arises if a policy becomes a Modified Endowment Contract (MEC). An MEC is classified if it fails the “7-pay test,” where cumulative premiums paid within the first seven years exceed a set limit. Once classified as an MEC, all distributions are treated as taxable income first, up to the gain, before returning tax-free basis.

The death benefit paid to beneficiaries from any life insurance policy, including MECs, remains income tax-free.