Anyone with dependents is wise to get life insurance, and millions of people do – everything from plain vanilla term policies that simply pay a death benefit, to fancier products such as whole life or universal life policies that build up a “cash value” that can be withdrawn or borrowed.
What’s the best way to manage this asset? Should you tap it only in an emergency? Use it to pay the policy’s premiums? Or feel free to spend it on things you couldn’t otherwise afford, like a new car or vacation?
“Cash value in a life insurance policy can really come in handy,” says Matthew Grove, senior vice president of New York Life. “Our clients use cash value to pay for everything from household repairs to weddings to retirement. Unexpected health or household emergencies are where the benefits of the fast access to cash value really prove important.”
Life insurance policies that build cash value can be complex, but many allow the policyholder to borrow against the policy or to withdraw cash permanently (a “surrender”), or to use the cash value to pay premiums, Grove says.
A surrender is a return of a portion of the premiums paid to that point, says Mark Teitelbaum, vice president of advanced markets at AXA Distributors in Charlotte, North Carolina. Loans and surrenders are generally tax-free so long as the cash value is less than the total premiums paid to that point.
“Usually the ability to tap life insurance cash surrender values is built into the contract design itself when the life insurance company develops the product,” Teitelbaum says. “Some products such as universal life have considerable flexibility. You might be able to withdraw cash values from the policy even when the contract is very young. Some types of contracts such as whole life may be less flexible and require a longer ownership period.”
Withdrawal rules can vary by policy, and are also regulated by federal tax rules that limit the size of the cash value relative to the policy’s death benefit. In some policies, the cash value may eventually grow to be nearly as large as the death benefit, and the policy holder can then decide whether to wait – for many years, perhaps – to leave the death benefit to heirs, or to get at that money immediately to spend or invest in another way.
“When cash is taken out of a policy it will reduce the amount of death benefit, and if too much cash is taken out of a policy it might eventually not be able to remain intact, or “in force,” in life insurance language,” Teitelbaum says. “If that happens and there was any positive appreciation in the policy, where the cash value had grown to be larger than the premiums paid for the policy, it could result in a tax bill to the client.”
A withdrawal, rather than a loan is “simply a withdrawal of an owner’s investment into the life insurance policy – the premiums paid,” he says. “So if they paid $10,000 a year for 10 years they could withdraw $100,000. Once funds have been withdrawn they cannot be put back into the contract, so even though tax free there’s a lack of flexibility. A client would want to weigh whether taking too much out could put the life insurance contract and death benefit at risk. ”
Taking the funds as a loan can leave the policy undamaged, as the loan and interest can be repaid. Interest rates are typically lower than on other types of loans, and the interest payment adds to the cash value.
Though insurers may make it easy to get at cash value, experts warn it’s unwise to plunder a life insurance policy for frivolous expenses.
“Retirement income is a major potential benefit of permanent life insurance,” Grove says. “For example, during the Great Recession when the financial markets were experiencing record lows, our clients could withdraw retirement income from their cash value instead of tapping into their investment accounts. This allowed their investment accounts to recover faster, ultimately leading to greater future income.”
A key issue: how much damage a withdrawal might do to the death benefit versus the value of shoring up other assets.
“If an individual is retired and withdrawing money from a qualified account (like an IRA or 401(k) to cover living expenses, it may make sense to minimize those liquidations in a down market by tapping cash value and allowing other assets to rebound in value” says Dave Simbro, senior vice president of life and annuity products with Northwestern Mutual Life Insurance Co.
“Since a withdrawal generally reduces the policy’s death benefit, a person who wants to maximize that payment should not withdraw cash value.”
“If there is a strong ongoing death benefit need, a client needs to weigh whether they are putting their death benefit amount or the life insurance contract at risk by taking too much cash out,” Teitelbaum says.
“In some instances it may make sense to borrow funds for short-term needs, such as a year of tuition, to tide over a business or for an item such as a wedding, if the client can repay the loan. In other instances, it might make sense to withdraw funds and reduce the death benefit if the client is retired, has a reduced death benefit need … and could put the funds to a different use.”