How to Use Life Insurance to Build Wealth

Life insurance primarily provides financial protection. However, certain policies also serve as a wealth accumulation tool, offering benefits throughout the policyholder’s lifetime. This involves using a policy’s cash value, which grows over time and can be accessed for various financial needs. This article explains how specific life insurance products build cash value, how to access these funds, and related tax considerations.

Understanding Cash Value Life Insurance

Cash value life insurance refers to permanent policies with a savings component. A portion of each premium payment contributes to this cash value, which grows over time separate from the death benefit. This accumulation creates a financial asset that policyholders can access during their lifetime.

The way cash value accumulates depends on the specific type of permanent policy. While the death benefit is the payout to beneficiaries, the cash value is the living benefit that can be utilized by the policyholder. This dual functionality distinguishes cash value policies from term life insurance, which only provides a death benefit for a specified period and does not build cash value.

Whole Life Insurance

Whole life insurance is a permanent policy with guaranteed cash value growth, fixed premiums, and a guaranteed death benefit. A portion of each premium is allocated to the cash value, growing at a predetermined, guaranteed interest rate. This predictable growth allows policyholders to anticipate how their cash value will increase over the years.

Many whole life policies may offer dividends, particularly from mutual insurance companies. If declared, these can enhance the cash value, reduce premiums, or purchase additional paid-up insurance. The consistent nature of whole life insurance makes it a stable option for long-term wealth accumulation, providing a reliable asset that is unaffected by market fluctuations.

Universal Life (UL) Insurance

Universal life insurance offers more flexibility than whole life policies, allowing policyholders to adjust premium payments and death benefits within limits. The cash value grows based on an insurer-declared interest rate, often with a guaranteed minimum. This rate may fluctuate with market conditions, but the minimum ensures some level of growth.

The flexible premium structure allows policyholders to pay more than the minimum, accelerating cash value growth. Sufficiently accumulated cash value can also cover future premium payments, offering financial adaptability. This feature can be particularly useful for individuals whose income may vary over time.

Variable Universal Life (VUL) Insurance

Variable universal life insurance includes an investment component, linking cash value growth to underlying investment options, called subaccounts. These subaccounts operate like mutual funds, offering choices such as stocks, bonds, or money market instruments, providing potential for higher returns.

However, VUL policies carry greater risk; cash value can decrease if investments perform poorly. Policyholders bear this investment risk, and cash value growth is not guaranteed. VUL policies are generally suited for individuals comfortable with investment risk who seek the potential for more aggressive cash value accumulation.

Accessing Policy Cash Value

Policyholders can access accumulated cash value through several methods. The terms depend on the policy contract and insurer rules. Understanding each method’s implications is important, as they can affect the policy’s death benefit and future cash value.

Policy Loans

Policy loans allow borrowing directly from the insurer, using accumulated cash value as collateral. These loans are not subject to credit checks, as the policyholder borrows their own money. Insurers typically allow borrowing up to 90% of the cash value.

Interest accrues on policy loans. While repayment is flexible, any outstanding loan balance, including interest, reduces the death benefit. Excessive loan growth can cause the policy to lapse. Policy loans are generally not taxable income, provided the policy remains in force and is not a Modified Endowment Contract.

Withdrawals

Policyholders can make direct withdrawals from their policy’s cash value. Unlike loans, withdrawals permanently reduce the cash value and its death benefit. The amount available for withdrawal is limited to the cash value that has accumulated.

Withdrawals are tax-free up to the amount of premiums paid into the policy (the cost basis). Any withdrawal exceeding this cost basis is considered a taxable gain, subject to ordinary income tax.

Policy Surrender

Surrendering a life insurance policy means terminating the contract and receiving the cash surrender value. This ends coverage and eliminates the death benefit. The cash surrender value is the accumulated cash value minus any surrender charges or outstanding loans and fees.

Surrender charges are fees for early termination, typically decreasing over time. The longer a policy has been in force, the closer the cash surrender value will be to the actual cash value. Any amount received upon surrender that exceeds total premiums paid is considered a taxable gain, subject to ordinary income tax.

Tax Considerations

The tax treatment of cash value life insurance is important for maximizing benefits and avoiding unintended tax consequences.

Cash value within a permanent policy grows on a tax-deferred basis. Policyholders do not pay taxes on interest or investment gains as they accumulate. Taxes are only due when funds are accessed, with specific rules for tax-advantaged access.

Policy loans are generally tax-free, viewed as a debt against the cash value rather than a distribution. This allows policyholders to use accumulated wealth without immediate tax implications, provided the policy remains in force. However, if the policy lapses or is surrendered with an outstanding loan, the loan amount exceeding the cost basis can become taxable.

Withdrawals from a cash value policy are tax-free up to the policyholder’s cost basis (total premiums paid). This is because the premiums were paid with after-tax dollars. Any amount exceeding this cost basis is a taxable gain, subject to ordinary income tax. The death benefit paid to beneficiaries is generally income tax-free.

Modified Endowment Contract (MEC) Rules

A Modified Endowment Contract (MEC) designation is a tax consideration for cash value life insurance. A policy becomes an MEC if premiums exceed certain IRS limits, failing the “7-pay test” for overfunding in its first seven years. Once classified as an MEC, this status is permanent.

The primary consequence of an MEC is a change in how withdrawals and loans are taxed. Instead of “first-in, first-out” (FIFO) taxation, MECs are subject to “last-in, first-out” (LIFO). This means distributions, including loans, are considered to come from taxable gains first.

Additionally, withdrawals and loans from an MEC are subject to a 10% federal penalty tax if the policyholder is under age 59½, similar to early withdrawals from a qualified retirement plan. This penalty applies to the taxable portion. While the death benefit remains income tax-free, the adverse tax treatment of living benefits makes MECs less attractive for flexible, tax-advantaged access.