A cash value life insurance policy refers to any permanent life insurance policy that includes a savings and investment feature. Generally, all life insurance policies have two components – a premium and a death benefit. Premiums refer to the amount you pay each month for life insurance coverage while the death benefit is the amount your named beneficiaries may get in the event of your death.
Permanent life insurance policies have a third component – cash value – which lets you build wealth through premium payments. With this type of policy, your life insurance premiums are divided into two portions, one for a death benefit and the remaining amount goes into cash value. You can access your policy’s cash value account while you are still alive, making it ideal for policyholders who want a living benefit.
The major plus with permanent life insurance is that it comes with multiple tax benefits for policyholders and beneficiaries. While the death benefit payout is tax free, cash value accumulation is either tax free or tax deferred. Depending on how the policy is structured, you may be able to access its cash value and not pay taxes on it.
Types of cash value life insurance policies
There are three main types of permanent or cash value life insurance policies: whole life, universal life, variable life.
Whole life
With a whole life insurance policy, you pay premiums at a fixed rate for the entire life of the policy. It offers a guaranteed death benefit and guaranteed returns on cash value (through interest and investments) as long as you pay premiums, making it one of the safest ways to grow your wealth while ensuring your beneficiaries are taken care of in your absence. The insurance company chooses and manages the best investments for your cash value.
Universal life
A universal life insurance policy allows you to increase or decrease your premium payments depending on your financial situation and coverage needs. The policy can either have a level or increasing death benefit.
With a level death benefit, your policy’s death benefit stays the same even if you increase premiums. Any extra payments go to building cash value. On the other hand, an increasing death benefit increases both components – i.e., the death benefit and cash value. Universal life policies typically have a guaranteed minimum death benefit but don’t guarantee returns.
Similar to whole life, a universal life insurance provider chooses and manages investments on your behalf. Some universal life policies are indexed, meaning that their performance mimics the stock market.
Variable life
Variable life insurance is similar to universal life in that it has flexible premium payments, no guaranteed returns, and provides savings and investment components. However, you are the one to decide how to invest the built-up cash value of a variable life insurance policy, much like you would in a brokerage account. And since it has no guaranteed returns, a variable life policy is riskier than other permanent life insurance policies. The upshot is that you always have the option to consult a financial professional before making investment decisions.
Cost basis vs. above basis in life insurance
In a permanent life insurance policy, “cost basis” or simply “basis” refers to the investment you make in the policy. This is the total sum of your premiums. Any cash value beyond your total premiums is called “above basis” and it refers to gains from interest and investments.
Say, for example, that you pay a monthly premium of $400 for a whole life insurance policy and that the policy earns interest at a rate of 8% per year. Your total premiums paid on any particular year would be $4,800 and interest earned would be $384.
In this case, your cost basis – your direct contribution through premium payments – would be $4,800 while your above basis amount – gains on life insurance premiums – would be $384. Assuming the basis and above basis amounts grow at those rates and that there are no other gains, your policy basis would be $48,000 and above basis amount would be $3,840 after 10 years.
Understanding the tax benefits of life insurance
Cash value life insurance is based on the premise of building cash value that you can tap into later on. Alongside a death benefit payout, there are two other ways of accessing the value of a permanent life insurance policy.
You can either withdraw cash value or borrow a loan against it. The latter two are living benefits because they give you access to the policy’s money in your lifetime. The entire process of building and accessing the cash value of a permanent life insurance policy comes with multiple tax advantages:
Tax-Free Growth of Cash Value
When you pay premiums on a cash value life insurance policy, a portion of the money goes into the policy’s death benefit and the remaining portion goes into building cash value. The cash value earns interest over time and, depending on your account, may also earn dividends.
You don’t owe taxes on these gains as long as the cash value remains in your account. For this reason, your money may grow faster because it’s not reduced by income taxes each year.
Tax-Deferred Accumulation of Funds
Not all cash value life insurance transactions are tax free; some are subject to income taxes. For example, the IRS requires you to pay taxes on withdrawals above basis amounts.1
However, you only have a tax liability if you withdraw money. Otherwise, your interest and investment gains are not taxable while they grow. This is called tax-deferred accumulation of funds, and it means that your money grows faster because it’s not reduced by income taxes each year.
Tax-Free Loans and Withdrawals
A permanent life insurance policy provides living benefits, meaning you can withdraw some or all the accumulated cash value. This may be necessary if you don’t have money but need to pay premiums, cover medical bills, or attend to any urgent expenses.
Whatever the case, any cash value withdrawals on the policy’s cost basis are tax-free. However, withdrawals on above basis amounts are subject to income taxes. To avoid tax obligations when you tap into your life insurance’s cash value, make sure the total amount withdrawn doesn’t exceed the policy’s cost basis.
Any loans you take out against a cash value life insurance policy are not taxable as long as the policy is in force. But if the policy lapses or if you surrender it when you have outstanding loans, you are required to pay income taxes on any amount above the cost basis.
For example, assume you borrow $20,000 against a whole life insurance policy and that $15,000 of the amount is from the premiums paid (your cost basis) while $5,000 is attributed to policy gains (your above basis). You will not owe taxes on any outstanding loan as long as your policy is in force. But if the policy lapses or if you surrender it, you will have tax obligations on the $5,000 – the above basis amount.
Tax-Free Death Benefit Payouts
Life insurance proceeds are not taxable since the IRS does not include death benefit payouts in ordinary income. In the event of your passing, your named beneficiaries will receive tax-free payouts from your life insurance company. This applies to all types of life insurance policies, including cash value policies and term life insurance policies.
In the case of cash value insurance, your beneficiaries receive the policy’s death benefit while the insurance company retains any unused cash value. The other thing to keep in mind is that tax-free life insurance benefits are only applicable to lump sum payouts. If your beneficiaries take their life insurance death benefit as installment payouts, they will be required to pay income taxes on any interest earned by the remaining benefit.
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Tax benefits of cash value life insurance compared to other investment vehicles
There are two types of investment accounts: taxable accounts and tax-advantaged accounts. While taxable accounts are subject to income taxes, tax-advantaged accounts are not and are instead tax-deferred or tax-exempt.
Taxable accounts are pretty common because they don’t have any tax advantages. Anyone can use them. They include savings accounts, brokerage accounts, checking accounts, and money market accounts. Although they are flexible and allow you to withdraw money any time and for any reason, these accounts don’t have any tax benefits.
When used as an asset, a cash value life insurance policy can act as a great investment vehicle because it is both tax-deferred and tax-exempt. Many other tax-advantaged accounts are either one or the other. For example, traditional 401(k) and IRA plans are tax-deferred because you must pay taxes on them when you withdraw your contributions in retirement.
Roth 401(K) and Roth IRA plans are tax-exempt, meaning that your contributions grow tax free and so are cash withdrawals in retirement. The trade-off for these tax advantages is that Roth 401(K) and Roth IRA plans are highly limited. If you withdraw money from them when you are under the retirement age, you will be forced to pay heavy penalties and taxes.
This is what gives permanent life insurance coverage an edge over alternative investment assets. In addition to providing a life insurance tax benefit, cash value policies allow you to access your cash value tax free even before you hit the retirement age. In most cases, you will only face a penalty if you surrender the policy. But even then, your insurance company will still give you the cash surrender value of the policy regardless of your age.
Eligibility and considerations for cash value life insurance
Only policies that provide permanent life insurance coverage are eligible for cash value accumulation. These policies include variable life, universal life, and whole life insurance policies.
Term life policies do not accumulate cash value, but they do have some tax advantages. Among the major term life insurance tax benefits is that death benefits are tax free, as is the case with cash value policies.
Qualifying factors for tax benefits
If you have a cash value policy, you can enjoy the tax advantages of life insurance when:
- You pay premiums: Life insurance premium payments are not taxable, and neither is the cash value they build as long as it remains in your policy account.
- You withdraw cash from the policy: You don’t owe taxes when you withdraw money from a cash value life insurance policy as long as the drawn amount doesn’t exceed the policy’s basis amount.
- You borrow a policy loan: Policy loans are loans borrowed against your policy from your insurance company. You don’t owe taxes on this type of loan as long as you keep your policy active.
- You borrow a collateral assignment loan: While policy loans are provided by insurance providers, collateral assignment loans are offered by third-party lenders using your life policy as collateral. As is the case with a policy loan, you are not required to pay taxes on collateral loans as long as your policy is in force.
- Your beneficiaries take a lump sum payout: Life insurance proceeds are not taxable when taken as a lump sum payout. Your beneficiaries need not worry about federal and state estate taxes. Generally, life insurance benefits may only be subjected to federal or state estate taxes if they are included in your estate. This happens if you fail to name a beneficiary.
- You sell your policy for a viatical settlement: A viatical sale of life insurance is when a terminally ill person sells their life insurance policy for immediate cash. Proceeds of this sale are considered life insurance death benefits and are therefore not taxable.
The tax implications of surrendering a cash value life insurance policy
As a policy owner, you can choose to surrender your policy to your insurance company for a cash payout. The insurer will give you the cash surrender value of the policy. This value is not taxable as long as it doesn’t exceed your policy’s basis. Any above basis amount is taxable.
Strategies for maximizing tax benefits
The easiest and best way to maximize life insurance tax advantages is to keep your policy active. As long as it is in force, you can access its cash value – either through withdrawals or by using the value as collateral for loans – without paying any taxes on the basis amount. In fact, it makes sense to only take out as much money as you have put into the policy. You generally won’t pay any taxes if you don’t use above basis amounts.
Leveraging cash value for tax-free income in retirement
One major advantage of building cash value in a permanent life insurance policy is that you can use it in retirement. Rather than tapping into the cash value in your younger years, you can let it grow on a tax deferred basis and then withdraw or borrow against the built-up value in your senior years. This is a safer way of retirement planning, especially with a whole life insurance policy which guarantees returns year-on-year.
Using Cash Value to Supplement Other Retirement Savings
Your life insurance company will not limit how you can use the cash value in your policy. As such, your options are endless, particularly if you let the cash value grow way into your retirement years. You can use the proceeds to:
- Pay off debts, including mortgages and credit cards
- Cover final expenses of a departed loved one
- Pay for living expenses
- Provide for your children and grandchildren who are not independent
- Cover your medical expenses, should you need to
Estate Planning Benefits and Tax Efficiency
Cash value policies are great tools for estate planning. For one, they offer life insurance death benefits that your dependents can turn to for income when you pass. Since the policy allows you to name multiple beneficiaries, you can use it to provide for multiple dependents and balance inheritance.
If you have other assets like property, your beneficiaries can use the proceeds of your policy to pay state estate taxes, administrative costs, and settlement expenses and preserve the physical assets in the family. In all these possible scenarios, the proceeds of the policy will not be taxed, making it a tax efficient way of estate planning.
Incorporating cash value life insurance into comprehensive financial plans
Some life insurance policies (like whole life) are great additions to your portfolio because they guarantee returns. Unlike other types of assets like mutual funds, stocks and bonds, life policies don’t fluctuate with market changes, making them great for portfolio diversification.
But before you decide to add a life insurance policy to your portfolio, talk to an insurance or investment professional to see if it’s a good idea. Although policies yield attractive returns, your personal situation and investment goals are the ones to ultimately determine whether having one in your portfolio is a good idea.
To learn more about whole life insurance or other coverage options, contact Fidelity Life today and speak with a trusted licensed life insurance agent. Or get started with a life insurance quote online.
Article Sources:
- Nerdwallet. “Is Life Insurance Taxable?, https://www.nerdwallet.com/article/insurance/is-life-insurance-taxable”
