Permanent life insurance policies, such as universal policies, variable and lifetime — provides more than a death benefit. Some include cash value, which is an amount of money that you can use while you’re alive.
If you’ve had a policy for years, the cash value can be significant. “The build-up 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 into 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 the terms of the policy. If you withdraw too early, the cash value of the policy could run out, forcing you to start paying more premiums or expiring coverage.
If you no longer need coverage, it can be tempting to stop the policy and cash in all of a sudden, but be aware of the tax ramifications, says Luke Chapman, partner at Precision Wealth Partners in New Castle, Del. . Any growth in the cash value greater than what you paid in premiums is taxed as ordinary income at the time of withdrawal. For example, if you have paid $ 20,000, have $ 100,000 in cash value and withdraw the difference, the $ 80,000 of growth is taxable.
There are better ways to harness that dollar value without increasing your tax bill.
A more tax-efficient option is to withdraw only what you need each year. Howard recommends keeping some money for an emergency fund, perhaps 12 months of spending, with the rest being used to supplement your retirement income. Withdrawals first take the tax-exempt premiums; taxes are only due once you start withdrawing the winnings.
You can also receive the cash value with a policy loan. You will not owe taxes for the withdrawal of winnings this way. In addition, you will have the option to refund the money, while you cannot reverse withdrawals. If the money is not repaid, the death benefit will cover the loan balance upon your death.
The insurer will charge interest on the loan. “The interest rate is determined by the policy contract and is specific to the operator,” Howard explains. “It’s usually 4 to 8% per year. ” Policy loan rates generally do not change based on market conditions, he said, so don’t expect a deal today just because overall interest rates are low. Your remaining cash value can be used to pay interest.
The IRS allows you to swap your permanent life insurance for an annuity through a 1035 exchange, which is a tax-free transfer from one contract 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 conversion to an annuity could generate $ 12,500, ”explains Chapman. An annuity could also guarantee that the payments will last your life, but you will cancel your life insurance policy, an irreversible decision.
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 it). You keep your life insurance, but a portion of the death benefit can be used to pay for long-term care expenses.
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 cautions against structuring the deal carefully, as there may be tax consequences. Always ask an insurance expert before using the cash value in this way.
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 alone, the cash value will continue to accumulate, leaving a larger inheritance for your heirsbecause withdrawals and loans reduce the final death benefit.