Life insurance is commonly considered a means to provide financial security for loved ones after we pass away. However, a life insurance policy can also be used as a financial tool to help build wealth. By taking advantage of the cash value component in a permanent life insurance policy, you can expand your investment options. In this article, we’ll explore how to use life insurance as an investment, whether it be to secure a loan or supplement your retirement savings.
A cash value life insurance policy accumulates a reserve that can be used outside of the policy’s death benefit. Cash value is a savings component only available with permanent life insurance policies that provides coverage for the entire lifetime of the insured, as long as premiums are paid. The premium payments you make are split between the policy’s death benefit, insurance company operating costs, and your policy’s cash value.
As you pay premiums, your policy's cash value grows. Plus, the cash value earns interest. This accrued cash value works as an investment vehicle that you can either borrow against or use as a cash reserve.
Despite your monthly payments, you may not have access to the cash value of your policy for a few years, depending on the terms of your policy. Another key factor to consider is that the cash value of your life insurance policy is only accessible during your lifetime. When you pass away, your beneficiaries only receive the death benefit of your policy. Any remaining cash value will go back to the insurance company. That's why it's crucial to understand the difference between term vs. whole life insurance.
A term life insurance policy differs from permanent insurance. With term life, your policy spans a certain number of years. At the end of the term, your coverage ends unless you renew the policy. Permanent life insurance coverage remains in effect until your death, unless you fall behind on your premiums.
While term life premiums are much lower than what you’ll pay for permanent insurance, these policies do not have a cash value. As a result, you likely won’t use term life insurance as an investment vehicle.
If cash is king, then you might be inclined to consider the benefits of cash value life insurance:
Flexibility. You can borrow against the cash value of the policy and use the funds to pay down debt, invest in an asset with a higher return, or even pay your premiums.
Potential growth. The premiums that go toward the cash value of your policy generate a return.
Tax-deferred. You can realize tax advantages when withdrawing cash.
Lifetime coverage. You have permanent life insurance coverage, as long as you pay your premiums.
Adjustability. Some cash-value life insurance policies — specifically, universal life insurance — let you change the death benefits and how much you pay in premiums each month.
Here are a few of the drawbacks:
Cost. Cash value life insurance is more expensive than term life insurance policies that cover a specific period of time.
Lower returns. Although the investment component of cash value life insurance policies can offer higher returns than a savings account, they often have lower returns than other options like stock market investments.
Benefit adjustment. Any unpaid loans and interest or withdrawals you make can reduce the death benefits paid to beneficiaries.
Fees and charges. Cash value life insurance policies often come with fees and charges, such as surrender charges if you cancel the policy early or fees for borrowing against the cash value.
There are two primary types of cash value life insurance policies:
Whole life insurance
Universal life insurance
While both permanent life insurance policies have a built-in cash value, each has its own features, as noted below.
Whole Life Insurance
Universal Life Insurance
Premium payments do not change as long as the policy remains in effect. Regardless of your age, you’ll pay the same monthly premium throughout the policy.
You can increase or reduce your premiums when you need to. While this can help out during times of financial difficulty, you may pay higher premiums to keep your policy in place.
The cash value of your policy grows at a guaranteed rate. You have some comfort in knowing the cash value will be worth at least a predetermined amount if you need to access the funds.
While the cash value grows at a guaranteed rate, the premium flexibility can change the projected cash value of your policy. There may be less certainty in how much the cash value is worth.
Cash account growth is tax-deferred.
Cash account growth is tax-deferred.
There is a guaranteed death benefit. However, any unpaid loans upon the policyholder’s death are subtracted from the guaranteed death benefit.
Some universal life insurance policies let you change the amount of the death benefit.
Since the returns and death benefits are guaranteed, whole life policies cost more than universal life insurance policies.
Since you can lower your monthly premiums and death benefit, universal life insurance policies cost less than whole life policies.
Making the choice between whole life and universal life depends on your financial situation and goals.
You customize whole life insurance to fit your financial situation when you first take out the policy. Once the policy is set, you don’t have to worry about rising premiums or decreasing benefits. Like a universal life policy, the cash value of your plan grows tax deferred. Plus, you may also receive dividends on your whole life policy. You can leave these dividend payments in your policy to increase your cash value, withdraw them in cash, or use them to pay premiums.
Universal life insurance offers flexibility throughout the policy period. So, if you’re concerned that you don’t have enough cash to make your payments, you can lower your monthly premiums so you don’t risk losing your coverage. You can also change the value of the death benefit if needed.
Compared with whole life coverage, universal life coverage is less expensive, and you have the ability to lower your premiums or benefit. However, the growth of your cash value and death benefits are not guaranteed in a universal life plan as they are with whole life insurance.
Before taking out a cash value life insurance policy, you should compare the coverage against your financial situation and goals. Once you’ve tailored the policy to fit your needs, you need to make monthly premium payments to keep the policy in effect. If you miss a payment, you could lose your policy.
Every monthly payment made is distributed across three buckets:
The death benefit
Insurance company costs
The cash portion of your policy
The amount allocated depends on your age. A younger policyholder may see more of their payment going toward their cash value in the beginning. The cash value grows as you continue to pay your monthly premiums. Since your cash account is like an investment, it generates a return that increases its value.
Suppose you purchased a cash value life insurance policy of $500,000 at the age of 30. After 20 years of paying your monthly premiums, you’ve accumulated a cash reserve of $250,000. If you were to pass away, your beneficiaries would receive $500,000 in death benefits. However, the $250,000 in cash would be forfeited to the insurance company. Therefore, the insurance company only realizes a loss of $250,000.
Using the same scenario above, you could leverage the $250,000 in cash value you have accumulated in a variety of ways, outlined below.
Rather than coming out of pocket each month, you can use the cash value of your policy to pay your premiums. Take the funds you would normally use to pay your life insurance premiums and invest these somewhere else. You could end up with higher returns than if you just left your money in the cash value of your policy.
You can borrow from the cash value of your policy. Since it is your money, you don’t need to go through a credit check, and you don’t need to pay it back if you do not want to. However, interest accrues when you borrow against the cash value of your life insurance policy. Any unpaid loans, interest, or fees at the time of death reduce the benefits paid to your beneficiaries.
You can withdraw the money and use it for something else, such as paying off your mortgage. You avoid paying taxes if the amount withdrawn is below the total premiums that you have paid. Like a loan, any amounts you withdraw are deducted from the death benefits paid to your beneficiaries.
The cash value of your policy can be used to supplement your retirement income. You can take withdrawals as you need to. If you no longer need life insurance, you may be able to convert your policy to an annuity. You may realize a higher rate of return, receive a steady stream of income, and avoid taxes.
You surrender your policy when you withdraw the entire cash value. You may decide to surrender your policy if your intended beneficiary has passed away or no longer needs death benefits.
For most people, taking out a life insurance policy to save for retirement may not be the best way to prepare for your future. A permanent life insurance policy can be costly and generate much lower returns than if you were to invest in a 401(k) or IRA. Consult with a financial advisor to help determine a financial plan that works for your future.
Despite these drawbacks, there are times when it may make sense to use life insurance for retirement. For example, you can withdraw the cash value without penalty. Yet, if you take a distribution out of your retirement account, you could be hit with an early withdrawal fee and be stuck paying taxes. If your insurance policy comes with a guaranteed rate of return, it could be more than what you earn by investing in a retirement plan.
Retirement planning with whole life insurance may also be an option if you have maxed out contributions to your 401(k) or IRA. A whole life policy may be helpful if you need lifelong coverage for estate purposes or to provide for a child with disabilities.
A permanent life insurance policy can be a powerful resource that can protect your family’s future well-being, as well as build wealth that you can use during your lifetime. With a cash value life insurance policy, you could supplement your retirement income or borrow money to pay off your mortgage.
While permanent life insurance policies are highly customizable, knowing what features work best for you requires thoughtful consideration of your finances and goals. A FinanceHQ advisor can design a plan that fits your financial needs today and meets the goals you have in mind for the future.
Anna Yen is a CFA charterholder, financial wellness expert, writer, and investor at FamilyFI.