Permanent life insurance policies, such as universal, variable and whole life – offer more than a death benefit. Some include cash value, which is a reserve of money that you can use during your lifetime.
If you’ve had a policy for years, the cash value could be substantial. “The accumulation could be more than what you invested, and that opens up all kinds of options,” says Jonathan Howard, certified financial planner at SeaCure Advisors in Lexington, Ky.
The cash value of permanent life insurance is your money, to be tapped as needed, but your options for doing so will depend on the type of policy and the insurer. Before you do anything, ask the insurer how much you can safely withdraw per year based on the cash value balance and policy terms. If you withdraw too much too soon, the policy’s cash value could run out, forcing you to start paying more premiums or cause coverage to lapse.
If you no longer need coverage, it can be tempting to shut down the policy and take it all out at once, but consider the tax ramifications, says Luke Chapman, partner at Precision Wealth Partners in New Castle, Del. Any growth in cash value greater than what you paid in premiums is taxed as ordinary income when withdrawn. For example, if you contributed $20,000, have a cash surrender value of $100,000 and withdraw the difference, the $80,000 of growth is taxable.
There are better ways to grow that cash value without increasing your tax bill.
A more tax-efficient option is to withdraw only what you need each year. Howard recommends saving money for an emergency fund, maybe 12 months of expenses, with the rest used to supplement your retirement income. Withdrawals first reduce tax-free premium payments; taxes are only due after you start withdrawing the winnings.
To borrow money
You can also leverage cash value through a policy loan. You will not owe taxes for withdrawing winnings this way. Moreover, you will have the option to refund the money, while you cannot reverse the withdrawals. If the money is not repaid, the death benefit will cover the loan balance when you die.
The insurer will charge interest on the loan. “The interest rate is determined by the insurance contract and is specific to the operator,” says Howard. “It’s usually 4% to 8% per year.” Policy loan rates generally do not change with market conditions, he says, so don’t expect a deal today just because interest rates are low overall. Your remaining cash value can be used to pay interest.
Redeem it for an annuity
The IRS allows you to exchange your permanent life insurance for an annuity through a 1035 exchange, which is a tax-free transfer from one policy to another. This move can generate more retirement income. “Let’s say the maximum payout stream for a cash value insurance policy is $10,000 per year. The annuitization could generate $12,500,” says Chapman. An annuity could also guarantee that the payments will last your lifetime, but you will be canceling your life insurance policy, an irreversible decision.
Convert to a new policy to pay for long-term care
If you want long-term care coverage, consider converting your life insurance to another policy with a long-term care rider (if yours doesn’t already have one). You keep your life insurance, but part of the death benefit can be used to pay for long-term care costs.
Use it as collateral
Cash value is an asset that increases your chances of qualifying for a loan or mortgage with a lender. It can even be used as collateral for the loan, but Chapman warns to structure the deal carefully, as there may be tax consequences. Always ask an insurance adjuster before using cash value in this way.
Tap it to pay the font
The cash value can also be used to cover your life insurance premiums.
You don’t have to do anything with your cash value. Left to its own devices, the cash value will continue to accumulate, leaving a larger legacy for your heirsbecause withdrawals and loans reduce the final death benefit.