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Showing posts with label insurance policy. Show all posts
Showing posts with label insurance policy. Show all posts
Wednesday, February 5, 2014
Wednesday, February 5, 2014
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At some point in our formative years we’ve had a parent or caregiver say to us “just because your friend jumps off a bridge doesn’t mean you should.” Of course they were trying to teach us that just because you can do something doesn’t make it a good idea. Borrowing against the cash value of your life insurance is a lot like that. You can do it, but it’s not always a good idea.
On the other hand, borrowing against life insurance cash value isn’t necessarily a bad idea either.
You see, borrowing against cash value is not a black and white issue – it’s very much dependent on individual circumstances and goals. The best advice I can give is to read up on the expert advice out there – articles like my own – until you feel you’ve developed a solid understanding of the advantages and disadvantages of borrowing from your policy; only then can you make an informed decision that is based on your actual circumstances.
As we’ve discussed in earlier articles, life insurance policies that build cash value, such as whole or universal life, are more costly than pure insurance term policies because part of that additional cost goes into building cash value. Building cash value takes time, but before you start building up your own, there are some risks you need to understand.
What is Cash Value?
Understanding cash value is vital to making an informed, effective decision. Cash value is a portion of your policy’s death benefit which has become liquid. It grows at different rates for different insurers. This is referred to as the rate of accumulation – the ROA. Universal life policies offer different options for how excess premium is invested, which will then result in a different rate of return for that policy. The risk comes from the fact that it is a part of your death benefit. This means that if you borrow against it and die while the loan is outstanding, the death benefit is reduced by the amount of the outstanding loan. So before you borrow against your accumulated cash value, one of the questions you should ask yourself is this:
If I die the day after I borrow the money, will there be enough death benefit left to fulfill my reason for buying the insurance in the first place?
It’s Not Free Money!
A very common misconception about borrowing money from life insurance cash value is that it is free money, a “no strings” and “no expense” sort of deal. This is simply not true. Life insurance companies are in business to make money, and when you withdraw cash value from a policy, the insurance company no longer has that money available to invest, cover overhead, or pay other beneficiaries claims, and so they charge interest to make up the difference.
Unlike a bank loan, you are not obligated to pay back a loan against your cash value; this might sound like a great deal – it’s not. The risk here is that the lack of a requirement to repay the loan means the loan never gets paid back. Interest on borrowed cash value will continue to accrue and eat away your death benefit, further reducing what will be there for your loved ones when you are gone.
Borrowing from the cash value of your life insurance does have some upsides, the biggest of which is the tax advantage. Withdrawals of any amount from the accumulated cash value of your whole or universal life policy is tax free up to the amount of the premiums you have paid. As a rule, withdrawals generally includes loans.
This tax free status is a lifetime benefit which means that it will continue to be untaxed as long as you live, even if you do not repay it. However, the tax free status ends with your death; any outstanding balance at that time is taxable. It is always advisable to check with an accountant before moving forward. Tax laws and regulations are always changing and it is better be safe than sorry.
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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