Wednesday, February 5, 2014
How to make and Borrow Cash From Your Life Insurance Policy
Life insurance comes in two basic flavors: term and permanent. Term insurance is pure insurance, and as such, its only benefit is the death benefit. Permanent insurance includes whole life, universal life and variable life, and has living benefits - foremost of which is the accumulation of cash value. Trent explored this topic in his earlier post, ‘Buy Term Life Insurance.’
Cornell University Law School defines “Cash Value” or “Surrender Value” as funds that are borrowed against or taken in whole upon surrender of the policy. The NOLO Plain English Law Dictionary goes on to say that, “The annual increase in the cash value of the policy is not taxed.” Tax-free growth and a ready source of loans make for a powerful statement about the value of life insurance as an asset to be leveraged.
There are differing opinions about life insurance as an investment and it really depends who you ask; some argue that anything other than term life is a bad idea, while others regard permanent life as the better choice. The fact is that, as investments go, life insurance is never going to provide a big return. That said, there is a place for life insurance in one’s portfolio beyond the death benefit but it requires you to understand the rules and risks.
The Ground Rules
First and foremost, your life insurance investment should provide death benefits that sufficiently cover all the needs of your loved ones and estate after you have died. To be clear, we will be discussing life insurance as a leverage device and not a provider of lost income.
Different forms of permanent insurance will accumulate cash at different rates. The slowest and most conservative is whole life; this option generally does not offer any options as to how your cash is invested and usually provides a fixed return in the form of an untaxed dividend. The tax advantage is that these dividends are treated as a return of premium and are not subject to being taxed.
Other types of permanent insurance (such as universal life policies) often provide the owner with options that focus on how excess premiums are invested, resulting in a higher return. Just like investments made in more conventional vehicles, the choice and greater return translate to greater risk. While some policies guarantee a minimum return, many do not. For further details about these policies, check out ‘The Simple Dollar Guide to Life Insurance.’
Personal Bank
The cash value that accumulates in a life insurance policy is like a personal bank account, in that the assets can only be drawn against by you and you are the loan officer. In a conventional bank, a loan officer reviews your credit and determines how much you can borrow and at what rate funds can be borrowed with only your approval.
Like a conventional loan, there is interest to pay – though it is usually lower than the going bank rate for a similar loan. The collateral for your policy loan is the death benefit, which means that if you should die before repaying the loan the death benefit will be reduced by the amount of the outstanding loan. Whole life policy loans have interest rates significantly below market rates and often have no interest at all.
Variable and universal life policy loans may also be subject to an opportunity fee or cost. This amount is calculated by finding the difference between the guaranteed rate the insurer is paying and the current rate of your investment selection. The difference is added to the interest rate you will have to pay on your loan. For example, if your guaranteed rate is 3% and your investment rate is paying 6%, then the difference of 3% is added to the interest rate of your loan.
Pros and Cons
The upside to borrowing against a life insurance policy is the low interest rate and lack of an approval process. It is quite easy to borrow against accumulated cash value, so great care must be taken to ensure that the face value (death benefit) is not so severely depleted that it defeats the purpose of having insurance altogether.
Accumulated cash value in a life insurance policy (including loans) is protected from creditors until it is removed. Borrowing funds from life insurance subjects them to attachment by creditors because they are no longer protected as part of the policy.
360 Degrees of Financial Literacy, a website maintained by the American Institute of Certified Public Accountants, notes that the proceeds of loans against life insurance cash value are non-taxable and (contrary to conventional loans) remain tax-free even when they are not repaid.
The Final Word
It is important to remember that the primary function of life insurance is to provide for the needs of your beneficiaries and that maintaining adequate coverage should be your priority. Life insurance as a leveragable financial tool is not for everyone. However, when the situation calls for it and you are in a financial position to take advantage of such policies, they can be the ideal solution to filling the need for a quick and easy infusion of cash.
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